A quick primer on exchange policy

On their own, threats of sanc­tions seem unlike­ly to move Chi­na. A “trade war” — say, a mas­sive, bilat­er­al, retal­ia­to­ry hike in trade bar­ri­ers between the USA and Chi­na — is a nuclear option in an era of glob­al sup­ply and pro­duc­tion inte­gra­tion. Sure­ly it’s a bluff because, inthe incan­des­cent lyrics of Tom Lehrer: “We will all go togeth­er when we go.”

The Chi­nese author­i­ties would be tempt­ed to believe that no-one would be that crazy, except… They have to be a lit­tletrou­bled by the Kissinger “mad-man” counter-bluff: do as I say or the mad-man in the White House (read “Con­gress” in this case) will gain the upper-hand and then… god knows what he (they) might do. Even if they don’t launch a “trade war”, the U.S. Con­gress or even hot-head­ed EU mem­ber states could fire a few real­ly cost­ly salvos. So we have to take the cur­rent pos­tur­ing semi-seriously.

But there are much more dif­fi­cult pol­i­cy ques­tions at stake for Chi­na in its exchange pol­i­cy. To under­stand these we have to look past the claims of delib­er­ate cheat­ing and manip­u­la­tion of glob­al imbal­ances. We have to think less about ideas of ‘equi­ty’ and ‘bur­den shar­ing’ among economies as they adjust to the rise and decline of eco­nom­ic pow­er and more about the dif­fi­cult ques­tions of tim­ing, sequenc­ing and pace that Chi­na’s eco­nom­ic man­agers are very like­ly debat­ing among them­selves. We have to think care­ful­ly about our inter­ests; obvi­ous­ly, these do not lie in changes that would under­mine the growth of the world’s most dynam­ic econ­o­my. It’s espe­cial­ly impor­tant to have an accu­rate assess­ment of the time-frame for any changes in China.

Below the fold I very briefly describe the strongest pos­i­tive argu­ment for a flex­i­ble, mar­ket-dri­ven, exchange rate, and three threats that a cur­ren­cy pegged to the U.S. dol­lar pos­es for growth and sta­bil­i­ty in the Chi­nese econ­o­my. The threat of for­eign retal­i­a­tion is not one of them.

Why does any gov­ern­ment want a flex­i­ble exchange rate, deter­mined by the mar­ket price of the nation­al cur­ren­cy? Most­ly because gov­ern­ments want mon­ey sup­ply to suit domes­tic needs, espe­cial­ly where the local busi­ness cycle of growth and slump dif­fers from the cycles in the rest of the world. A flex­i­ble exchange rate helps ensure the mon­ey sup­ply in an open econ­o­my adjusts, “auto­mat­i­cal­ly”. In a peri­od of local con­trac­tion, there’s less demand for the nation­al cur­ren­cy, so the exchange rate falls in the mar­ket-place. Local assets and out­put start to look cheap to for­eign­ers. In the absence of cap­i­tal con­trols funds flow in, exports flow out, busi­ness recov­ers, the econ­o­my starts to expand, prices rise, inter­est rates firm, the exchange rate too. The ris­ing exchange rate helps con­trol infla­tion as the econ­o­my sucks in imports while the ris­ing (for­eign) price of exports starts to take some of the steam out of the expan­sion­ary phase.

None of this needs gov­ern­ment inter­ven­tion, but it needs a sophis­ti­cat­ed finan­cial sys­tem to work smooth­ly. In an econ­o­my where the finan­cial sys­tem is weak, where finan­cial mar­kets are not uni­form­ly well-informed, where there are still some offi­cial cap­i­tal con­trols in place (e. g. to sup­port devel­op­ment plan­ning), and espe­cial­ly where growth is export-depen­dent, the author­i­ties want to hold onto exchange rate con­trols since un-con­trolled cur­ren­cy move­ments will like­ly be volatile (unin­formed, pre­cau­tion­ary, spec­u­la­tive) and can eas­i­ly under­mine finan­cial sta­bil­i­ty and growth. This is, more or less, still Chi­na’s case.

Up to now, Chi­na’s export-led growth strat­e­gy (or ‘re-export-led’ to be more accu­rate), pro­tect­ed banks and nascent equi­ties mar­ket argued for exchange con­trols. But, as you can prob­a­bly guess, there’s no free lunch. There’s poten­tial­ly a big price to pay for con­trol­ling the exchange rate. First, it means that local finan­cial con­di­tions are “pegged” to finan­cial con­di­tions and inter­est rates in the rest of the world: your mon­ey sup­ply tends to track their mon­ey sup­ply even when com­plete­ly wrong for your local mar­ket con­di­tions (this is also, of course, the fun­da­men­tal prob­lem with the Euro­pean mon­e­tary union: the Euro). Gov­ern­ments have to fall back on usu­al­ly-ugly local fix­es and crude mon­e­tary instru­ments (the print­ing press, bank con­trols) to main­tain growth, and often have to deal with the fall­out from those fix­es lat­er using oth­er crude methods.

Sec­ond, Gov­ern­ments with fixed exchange rates are lay­ing them­selves open to being gamed by spec­u­la­tors when they start to open up the local cap­i­tal mar­ket as part of a strat­e­gy to encour­age for­eign (and local) invest­ment. Large cap­i­tal inflows push up the real exchange rate what­ev­er the offi­cial rates may be. This is infla­tion­ary and desta­bil­is­ing so gov­ern­ments man­ag­ing a fixed rate are under con­sid­er­able pres­sure to move the rate up to hose down the infla­tion. But as soon as they do so, they reward the spec­u­la­tive cap­i­tal investor who now with­draws the cap­i­tal at the high­er exchange rate and with a tidy prof­it. Fur­ther desta­bil­i­sa­tion and a slump in growth. 

This was a wide­ly-noticed les­son from the Asian finan­cial mar­ket cri­sis in the late 1990s. Gov­ern­ments that lib­er­alised their cap­i­tal mar­kets before they lib­er­alised their exchange rates (and before their finan­cial mar­kets were real­ly ready for it) were pun­ished by spec­u­la­tion: sequenc­ing mat­ters.

Third, Chi­na wants domes­tic demand, not export demand, to be the main dri­ver of growth in the future. That is the inevitable con­se­quence of the high­er indi­vid­ual incomes that come with macro-eco­nom­ic growth: pop­u­lar demand for high­er liv­ing stan­dards. It’s the reward for devel­op­ment so you can be cer­tain that the Com­mu­nist Par­ty wants this just as much as any­one else, despite the awk­ward (but con­tain­able?) demand for more indi­vid­ual lib­er­ty that accom­pa­nies greater indi­vid­ual wealth.

When domes­tic demand starts to dri­ve growth, gov­ern­ments want mon­ey sup­ply to match the needs of the local busi­ness cycle with­out heavy-hand­ed inter­ven­tion. They try to min­imise invest­ment and cap­i­tal con­trols. They pre­fer to open goods and ser­vices mar­kets to ensure com­pet­i­tive sup­ply to from both domes­tic and for­eign sources, keep­ing infla­tion down and ensur­ing the tech­no­log­i­cal exchange that sus­tains con­tin­u­ing export suc­cess. A flex­i­ble exchange rate is essen­tial in this envi­ron­ment, which is near­ly or at worst soon like­ly to be Chi­na’s case. The prob­lem is one of tran­si­tion from here to there: the sequenc­ing problem.

Mean­while, know­ing that Chi­na has to dig itself out of the fixed exchange rate regime if it wants to grow, what should for­eign­ers do about the cur­rent under­shoot in the Chi­nese rates? Keep the pres­sure up, but do no last­ing harm is the best approach. But it’s a dif­fi­cult judge­ment to apply the heat just enough to keep the Chi­nese focussed on fix­ing the prob­lem but not so much that it encour­ages com­pet­i­tive exchange-rate pro­tec­tion­ism. Some bound­ed scrap­ping between Chi­na, the EU and the USA might be no bad thing. Plau­si­ble safe­guard duties on a small range of prod­ucts, intro­duced in good form fol­low­ing the WTO safe­guard pro­vi­sions would be bet­ter than allow­ing the rhetoric to become much sharper.

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