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Thursday, June 22, 2006

The "China Bashing" Trap

Ronald McKinnon of Stanford University explains why "China bashing" is a bad idea through a comparison of the pressure being applied on China today to revalue the yuan with a period 30 years ago when similar pressure was applied to Japan to revalue the yen with less than desirable results. Some highlights:

The Problem with “China Bashing”, by Ronald McKinnon, Commentary, Project Syndicate: Pressure on China today to push up the value of the yuan against the dollar is eerily similar to the pressure on Japan 30 years ago to make the yen appreciate. Back then, “Japan bashing” came to mean the threat of US trade sanctions unless Japan softened competitive pressure on American industries. By 1995, the Japanese economy had become so depressed by the overvalued yen ( endaka fukyo ) that the Americans relented and announced a new “strong dollar” policy. Now “China bashing” has taken over, and the result could be just as bad, if not worse. ...

The financial press and many influential economists argue that a major depreciation of the dollar is needed to correct America’s external deficit. But the US current-account deficit – about 6% of GDP in 2004 and 2005 – mainly reflects a new round of deficit spending by the US federal government and surprisingly low personal savings by American households (perhaps because of the bubble in US residential real estate).

Moreover, the cure can be worse than the disease. Sustained appreciation of a creditor country’s currency against the world’s dominant money is a recipe for a slowdown in economic growth, followed by eventual deflation, as Japan found in the 1990’s – with no obvious decline in its large relative trade surplus. In a rapidly growing developing country whose financial system is still immature, introducing exchange-rate flexibility..., as the IMF advocates, is an even more questionable strategy.

If a discrete exchange-rate appreciation is to be sustained, it must reflect expected monetary policies: tight money and deflation in the appreciated country, and easy money with inflation in the depreciated country. But domestic money growth in China’s immature bank-based capital market is high and unpredictable, while many interest rates remain officially pegged. Thus, the People’s Bank of China (PBC) cannot rely on observed domestic money growth or interest rates to indicate whether monetary policy is too tight or too loose. ...

If China is to avoid falling into a Japanese-style liquidity trap, the best solution is to fix its exchange rate in a completely credible way so that there is no fear of currency appreciation. Then financial liberalization could proceed with market interest rates remaining at normal levels. But China’s abandonment of the yuan’s “traditional parity” in July 2005 rules out a new, credibly fixed exchange-rate strategy for some time.

Failing this, China must postpone full liberalization of its financial markets. This means retaining, and possibly strengthening, capital controls on inflows of highly liquid “hot” money from dollars into yuan, and continuing to peg certain interest rates, such as basic deposit and loan rates, to help preserve the profitability of banks.

Such measures are, of course, an unfortunate detour. True, China’s economy is now growing robustly and is not likely to face actual deflation anytime soon, but if China does fall into a zero-interest rate trap, the PBC, like the BOJ, would be unable to offset deflationary pressure in the event of a large exchange-rate appreciation. With short-term interest rates locked at zero, pressure for further appreciation would leave the PBC helpless to re-expand the economy.

China’s monetary and foreign exchange policies are now in a state of limbo. Instead of stable guidelines with a well-defined monetary (exchange rate) anchor and a firm mandate to complete financial liberalization, China’s macroeconomic and financial decision making will be ad hoc and anybody’s guess – as was true, and still is, for Japan.

With so many different analyses of global imbalances, with so many different policy recommendations about how to resolve them and who is at fault, and with dire warnings about every policy choice from some credible analyst, this must be pretty confusing to people with little training in the area. Quite honestly, it's pretty confusing even if you have had training and the main message seems to be that the future holds a great deal of uncertainty even for those who have studied these problems extensively.

So, since I have nothing in particular to add to the confusion on this issue that someone hasn't already said, I'll go, with appropriate apologies, to a corny, worn out analagy type ending. Should you buy an umbrella to ward off the coming economic storm? Changes in the economic weather, like changes in the weather more generally, are hard to predict until signs of change are evident. So far the clouds that are visible aren't gathering into a storm, but I wonder, is your economist uncle's arthritic knee, the one he swears predicts big storms, aching yet?

    Posted by on Thursday, June 22, 2006 at 03:42 PM in Economics, International Finance, Policy, Politics | Permalink  TrackBack (0)  Comments (9)


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