China is being pressured to halt its interventions to prop up the US dollar in world currency markets, with opponents emphasizing how much harm the policy is causing to other countries. But authorities in Beijing might respond more favorably to an argument that points out how China's own economic health might benefit from abandoning the current exchange-rate policy, which pegs the yuan to the dollar.
Such an argument is not difficult to make. China is currently pursuing a contradictory set of policies that paradoxically undermines its own economy while propping up America's by accommodating the US Federal Reserve. China and Hong Kong are two of the largest net purchasers of US Treasury securities. Otherwise, Treasury bond yields would be far higher, thwarting monetary expansion by the Fed.
Back in China, the dollar peg has led to large and growing foreign-exchange reserves, which are fueling domestic inflationary pressures and causing public-sector debt to balloon. This is because official capital controls oblige exporters to deposit hard currencies with the People's Bank of China in exchange for freshly printed yuan (usually as bank deposits) or government debt. Both arrangements will eventually become untenable, because they will generate either an intolerable rate of inflation or an unsustainable burden of public-sector debt.
These are high prices for China to pay to maintain its policies, including the pegged exchange rate. There is a great deal of volatility in foreign-exchange markets across the globe, mainly owing to the weakening of the dollar. As such, China and other countries are holding a depreciating asset that should be managed in order to serve domestic interests rather than those of the US.
Chinese policymakers should bear in mind that the value of the yuan is only one among many factors that affects the competitiveness of China's economy. After all, a currency can appreciate while an economy is sluggish, or depreciate despite robust growth.
As it is, the valuation of a country's currency is not so much determined by the performance of its economy as by the forces of supply and demand on foreign-exchange markets. For a given supply of money, an increase in the production of goods will increase the value of a currency, because each unit will buy more goods. Likewise, increasing the supply of money relative to a fixed amount of output will lead to a decline in the purchasing power of money, as each currency unit buys fewer goods.
So it is nonsense to declare that China's currency is currently undervalued. We can only know that once all economic players have the opportunity to decide freely on where they wish to place their financial assets. Given the high rate of growth in China's money supply, there could be considerable pressures for the yuan to actually depreciate, because a rate of monetary growth that exceeds the growth rate of economic activity tends to cause a currency's exchange rate to fall.
If exchange rates were fixed but capital could move freely, capital flight from the country would generate pressures to end loose monetary policies.
The debate over how to value the yuan is at the heart of the two-year struggle by the country's policymakers to slow down China's overheating economy. One response was the decision by the People's Bank of China to increase the one-year interest rate from 5.31 percent to 5.58 percent -- its first rate hike in over nine years -- in an effort to staunch increasing prices, and offset a worrying decline in savings.