Pressure on China today to push up the value of the yuan against the US 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 US industries. By 1995, the Japanese economy had become so depressed by the overvalued yen 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.
By 2000, China's bilateral trade surplus was as large as Japan's; by 2004, it was twice as large. Whereas Japan bashing included "voluntary" restraints on exports that threatened US heavy industries, where lobbies were concentrated and politically potent, recent Chinese exports have mainly been low- to middle-tech products of light industry. Thus, China bashing primarily means pressure to revalue the yuan. But this demand is as unwarranted now as was pressure on Japan to make the yen appreciate.
The financial press and many influential economists argue that a major depreciation of the greenback is needed to correct the US' external deficit. But the US current-account deficit -- about 6 percent of GDP in 2004 and last year -- 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 currency is a recipe for a slowdown in economic growth, followed by eventual deflation, as Japan found in the 1990s -- with no obvious decline in its relatively large trade surplus.
In a rapidly growing developing country whose financial system is still immature, introducing exchange-rate flexibility in order to insulate domestic macroeconomic policy from the ebb and flow of international payments, 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.
From 1995 to July 21 last year, Beijing held the exchange rate constant at 8.28 yuan/dollar (plus or minus 0.3 percent). They subordinated domestic policies to maintaining the fixed exchange rate -- even during the 1997-1998 Asian financial crisis, despite great pressure to devalue. They also dismantled tariffs and quotas on imports faster than their WTO obligations required.
Greater economic openness, coupled with the fixed nominal exchange rate, ended China's inflationary roller-coaster ride, and, after 1994, real GDP growth also became more stable. The government is now seeking to decontrol domestic interest rates, create a more robust domestic bond market, and finally remove capital controls. However, with China's economy currently threatened by ongoing yuan appreciation, liberalizing the financial system could have perverse short-run consequences.