In a liberalized capital market, the undiminished risk that the yuan might appreciate means that investors must be compensated by a higher interest rate on dollar assets. But interest rates on dollar assets are given in world markets independently of what China does. Thus, the market can establish the necessary interest differential only if interest rates on yuan assets fall below their dollar equivalents.
As the huge buildup of dollar reserves -- now almost US$800 billion -- expands China's domestic monetary base, short-term interest rates will be driven down, at least until they hit zero. Last month, the fairly free domestic interbank rate was just 1.62 percent, while the US Federal Funds rate was 5 percent.
Just letting the yuan float upward does not resolve the dilemma. Actual appreciation would lead to actual deflation and further downward pressure on domestic interest rates. If actual appreciation does not reduce China's trade surplus, pressure to appreciate the yuan further would only continue, as was true for Japan before 1995.
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" last July 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 strength-ening, 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 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 Bank of Japan, 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.
Ronald McKinnon is a professor of economics at Stanford University.
Copyright: Project Syndicate
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