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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