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Tuesday, August 29, 2006

A Monetary Rule for China

Ronald McKinnon argues that China's revaluation of the yuan over the past year was needed to maintain price stability in light of the surprisingly high rate of inflation in the U.S. This leads to a monetary rule for China where any change in the value of the monetary anchor - i.e. changes in the inflation rate in the U.S. - is offset with changes in the exchange rate between the dollar and the yuan:

The Yuan and the Greenback, by Ronald McKinnon, Commentary, Wall Street Journal: China's central bank anchored the national price level from 1994 to Sept. 21, 2005, by keeping its currency, the yuan, fixed at 8.28 yuan to the U.S. dollar. The policy was a great success: Over that period, China's consumer price inflation dropped to around 1% to 2%, from more than 25%, and inflation-adjusted GDP grew at a healthy 9% to 10% clip per year.

Today, however, the U.S. monetary anchor isn't as stable as it once was. U.S. inflation is spiraling up, with consumer prices rising to 4.1% and producer prices to 4.2% on a year-on-year basis through last July. Clearly, China's foreign monetary anchor is slipping. Worse, the Federal Reserve Bank has been indecisive about caging the inflation dragon, leaving the interbank federal funds rate at just 5.25% -- an unduly stimulatory level -- at its August meeting...

The initial motive for unhooking China's peg to the dollar was probably to defuse -- or confuse -- misguided American political pressure to appreciate the yuan's value versus the greenback. The premise of such arguments, that yuan appreciation would reduce China's large and growing trade surplus, is widely held but wrong. The trade imbalance between China and the U.S. results from China's high savings combined with the opposite tendency in the U.S., neither of which is predictably affected by changing the yuan-dollar exchange rate.

China's inflation is, however, predictably affected by sustained exchange-rate changes. Although unhooking the yuan-dollar exchange rate to reduce China's trade surplus was wrongly motivated, the subsequent small appreciation has had a positive effect: It's helped to insulate China from surprisingly high U.S. inflation. ...

China's consumer price inflation registered just 1% over the year through last July, while the U.S. rate hit 4.1%. This inflation differential of 3.1 percentage points was consistent with the yuan's appreciation of 3.3% year over year, as the chart nearby shows. That the inflation differential mimicked the appreciation so closely is partly a statistical coincidence, and probably unlikely to happen again. Nevertheless, cause and effect are ... important. ...

This reasoning leads to a new monetary rule for China: Pick some target rate for annual inflation in China's CPI, say 1% ..., then see how much higher American inflation, say 4.1%, is above China's internal target rate. The difference, in this case 3.1%, then becomes the planned annual gradual appreciation of the yuan rate against the dollar. ...

Floating the yuan, which would lead to a large initial appreciation, would be a major policy mistake. China's trade surplus would continue unabated, with a continued accumulation of dollar claims by the private sector that would force successive appreciations of the yuan until the central bank was again forced to intervene and stabilize the rate at a much appreciated level. By then, expectations of ongoing appreciation and deflation in China would be firmly in place. That scenario could mimic what happened to Japan with its ever higher yen in the 1980s through the mid-1990s -- a deflationary slump, coupled with a zero interest liquidity trap and its "lost" decade of the '90s.

The bottom line is that China's central bank must carefully watch inflation and interest rates in the U.S. when formulating its own exchange-rate-based monetary strategy. Any exchange-rate changes against the dollar should be tightly controlled and gradual -- as with the appreciation over the past year.

A simple way to think about this is to use the long-run purchasing power parity (PPP) condition. This condition states that in the long-run the exchange rate is the ratio of the price level in each country, or E = P/P* where P is the U.S. price level, P* is China's price level, and E is the $/yuan exchange rate (a larger E is a depreciation in the dollar and an appreciation in the yuan, and yes, I know that there are problems with PPP).

Now, if E is fixed the U.S. can export its monetary policy to China. To see this, suppose that the U.S. inflation rate, i.e. the rate of increase in P, is 4%. Then P* must increase by 4% as well to keep E constant. Thus, the U.S. monetary policy of a 4% inflation rate must be adopted by China to maintain the fixed exchange rate and the U.S. has exported its policy to China. If China wants a zero inflation rate, then it must abandon a fixed exchange rate and let E  increase by 4% a year (which is an appreciation in the yuan of 4% per year) to match the increase in P. In that case P* = P/E would be constant.

    Posted by on Tuesday, August 29, 2006 at 12:15 AM in China, Economics, International Finance, Monetary Policy | Permalink  TrackBack (0)  Comments (4)

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