The U.S. is “Taking on China”

In a recent New York Times column Paul Krugman is “Taking on China” again. He argues that the Chinese dollar peg contributes to global imbalances, depressing US and world growth perspectives. Bashing China’s fixed exchange rate is also fashionable in academics. Bernanke blames China’s dollar peg for contributing to a “savings glut” that contributed to the US pre-crisis excesses. Dooley argues that China and other East Asian economies engage in mercantilist trade strategies. Bergsten wants to label China a “currency manipulator.”

We find these arguments unbalanced. Fixed exchange rates do not cause balance of payments misalignments themselves (see Hanke). Whereas with a floating exchange rate the monetary policy is determined by the central bank and the exchange rate is left to the market, a credible peg targets exchange rates and leaves money supply to market forces. Both systems allow for a market driven adjustment. Economies with underdeveloped goods and capital markets have been using pegs for decades to import macroeconomic and financial stability. The peg itself cannot be the problem.

The problem is that the Peoples Bank of China is forced to target both the exchange rate and money supply. As the huge foreign reserve accumulation expands the money supply beyond what is tolerable for domestic price and financial stability, the Chinese central bank mobs up surplus liquidity by increasing (inter alia) reserve requirements. The resulting real exchange rate stabilization distorts the goods market sector, as exports are subsidized.

In addition, to save costs and to prevent a rise in interest rates (which would attract new capital inflows) sterilization is done by coercion below market rates. This distorts financial markets as the resulting surplus demand for capital is allocated politically through the state controlled financial system in favor of the export sector.

Should China Float or Stop Sterilization? – If China floated the yuan, the export sector would collapse and unemployment would soar. Given unprecedented low world interest rates, signaling yuan appreciation would attract a tsunami of speculative money inflows seeking for easy profits from appreciation. This would step up inflation and asset prices, as it happened in Japan after the 1985 Plaza-appreciation (McKinnon and Schnabl). Stopping sterilization would open the door to bubbles and inflation as well because the US as anchor economy continues its very easy money policies. China is caught in a policy trap! Any policy move will cause unpleasant turbulences unless the US returns to inflation neutral policies.

Thus, the only way out of the dilemma would be a coordinated move by China and the US. The Federal Reserve would have to return to an inflation neutral policy stance to dry out the source of hot money inflows into China. China would have to stop non-market based sterilization to end the subsidies for the export sector. But instead of aiming at a cooperative exit – from what Hayek might have called “monetary nationalism” – to correct global imbalances, the US pushes for confrontation via economic sanctions. This may lead to minor yuan appreciations to please the US public, but does not solve the problem of two economies whose economic faith is inescapably intertwined.