Complacency on Currency Reform Threatens China

(April-May 2006) 

Discussions between the United States and China on the currency issue have been carried out on a basis of mutual respect and frank dialogue.  Secretary Snow applauded China’s move to a managed float last July as an important first step. But the risks of not moving more ambitiously on exchange rate reform are growing.   Distinguished academic supporters of a rigid exchange rate for China have predicted dire economic consequences if China were to move towards greater exchange rate flexibility. While I have great respect for their contributions to this debate, experience suggests that they are wrong.

The United States’ advocacy of a flexible yuan for China is based on our belief that a flexible currency would benefit both the United States and China.  Domestically, exchange rate flexibility offers China more effective tools to avoid credit-fueled boom/bust investment cycles and would promote China’s transition to a market-oriented economy. Internationally, greater currency flexibility will reflect China’s serious consideration of its role as part of the shared solution to unwinding global imbalances and ensuring continued global growth without protectionism.

The U.S. Treasury is not seeking a one-time currency adjustment, a move that would only have a short-term impact. Nor do we believe that greater currency flexibility alone can lead to a reduction in global trade imbalances. As Secretary Snow noted on May 18, this is a shared responsibility which will also require higher savings in the United States (mainly through a smaller fiscal deficit) and higher domestic demand-led growth in Europe and Japan.

Some distinguished scholars suggest that greater exchange rate flexibility would be destabilizing, and have attributed China’s record of economic and price stability to its currency peg. But those advocates of exchange rate rigidity are ignoring the need for flexibility in averting future instability in China, Asia and the global economy.

Reliance on command-and-control tools led to a series of credit-fueled, boom/bust investment cycles between the 1970s and the mid-1990s. These administrative tools have lost their effectiveness in a larger, more market-oriented and globally integrated economy. Administrative guidance from the government also runs counter to China’s laudable efforts to reform its banks to operate more on commercial terms. China is engaged in an historic transformation to a market-based system, but it needs modern policy tools to support that transformation. Relying on price signals, including exchange rates and interest rates, is increasingly important to direct resources efficiently and maintain macroeconomic stability.

An inflexible currency limits the ability of China’s monetary authorities to adjust interest rates and money growth. Large current account surpluses and capital inflows, which the central bank must buy up to maintain the peg, have produced excessive liquidity growth which is fueling inefficient investment and excess capacity, raising the risk of another boom/bust cycle, this time with far greater global implications. According to Xinhua News, Premier Wen Jiabao recently told the State Council that China’s "main economic problems are overly fast growth in fixed-asset investment and credit." Fixed-asset investment rose 30 percent in the first five months of this year, and real estate investment rose by 21 percent over the same period. Bank credit for the first five months has already reached almost three-quarters of the central bank’s annual target. Rapid credit growth is also undermining the government’s efforts to improve the quality of lending and avoid a new accumulation of non-performing loans.

The policy mix that arises from a rigid exchange rate – rapid credit growth and low interest rates – reinforces unbalanced growth in China. Almost 60 percent of GDP growth now comes from investment, and the investment share of GDP -- already very high -- continues to climb. Low interest rates encourage use of capital at the expense of labor. As a result from 2001-04 while Chinese real GDP grew 8.5 percent per year, employment rose by only 1 percent per year. Moreover, urban unemployment rose from 3.6 percent to 4.2 percent over this period, despite rapid growth.

In spite of these trends, certain academics continue to argue, mistakenly, that the dollar can serve as a rudder for China as it did for Japan. But the comparison with Japan is incorrect. Japan’s experience in the 1980s and 1990s serves as a reminder of the perils of monetary policy that veers from a focus on price stability. Japan’s bubble emerged due to an overly loose monetary policy in the 1980s, due in part to efforts to prevent currency appreciation. China, with its current rigid exchange rate and large foreign exchange inflows, risks the same kind of liquidity-induced asset price bubble. Backers of a rigid exchange rate regime also neglect to mention that Japan’s economy grew rapidly in the 1970s despite a 100 percent appreciation of the yen as the Bretton-Woods fixed exchange rate system yielded to the current floating exchange rate system.

While China has made some progress, its actions overall on the exchange rate regime have been far too cautious. It is easiest to exit a rigid currency regime when growth is strong, financial markets are receptive, and the shift is likely to be orderly.

Ironically, the Chinese authorities understand this and have committed to greater exchange rate flexibility and important measures to rebalance growth, including as part of their latest five-year program. In his April visit to Washington, Chinese President Hu announced that “China will continue to develop the foreign exchange market [and] increase the flexibility of the exchange rate.” The time to act is now. A government with more effective policy tools will produce a more stable economy less prone to booms, busts and bubbles. This benefits both China and the United States.