Wed, Apr 16, 2014 - Page 9 News List

China’s currency conundrum rests in dollar dilemma

China sits in a currency trap, owing to its own surplus of savings, the deficiency of savings in the US and near-zero interest rates on US dollar assets, and will remain trapped until the global economy improves

By Ronald McKinnon

The People’s Bank of China (PBOC), it seems, cannot win.

In late February, the gradual appreciation of the yuan was interrupted by a 1 percent depreciation (to 6.12 yuan against the US dollar:). Though insignificant in overall trade terms, especially when compared with the volatility of floating exchange-rate regimes, the yuan’s unexpected weakening sparked a global furor.

The uproar was not surprising. After all, China has been under constant pressure from foreign governments to revalue, in the mistaken belief that a stronger currency would reduce China’s large trade surplus. And, since July 2008, when the exchange rate was 8.28 yuan to the US dollar (and had been held constant for 10 years), China’s central bank has more or less complied, with appreciations approximating 3 percent per year through 2012.

However, the international outcry obscured an unintended, but perhaps more troubling, feature of China’s exchange-rate policy: The tendency for sporadic yuan appreciation (even small movements) to trigger speculative inflows of “hot” money. With short-term interest rates in the US near zero and the “natural” interbank interest rate in faster-growing China at almost 4 percent, an expected 3 percent appreciation, for example, translates into an “effective” interest-rate differential of 7 percent. This is an enticing spread for currency speculators who borrow in dollars and circumvent China’s capital controls to buy yuan assets.

The hot-money problem is only made worse by the ongoing international pressure for further yuan revaluation, usually from Western economists and politicians who blame the exchange rate for China’s current-account surplus with the US and other developed economies.

The trade imbalance reflects the difference between China’s large savings surplus and the even bigger US saving deficiency (largely explained by the US fiscal deficit). The wholesale price index — the best measure of tradable-goods prices in China — has been falling by about 1.5 percent annually, which suggests that the yuan may even be slightly overvalued.


Simply put, exchange-rate movements do not properly correct net trade (saving) imbalances between open economies; but they can increase hot-money flows. So China’s central bank tried to keep speculators off guard by introducing more uncertainty into the exchange-rate system, as occurred with February’s surprise devaluation. In the middle of last month, the bank said that the daily movement in the yuan/dollar rate would be increased from about 1 percent to about 2 percent, to further dampen hot-money speculators’ enthusiasm. While this is all well and good, speculative inflows would be further dampened if today’s central rate, say, 6.1 yuan to the US dollar, was stabilized into the indefinite future.

There is less-discussed justification for holding the currency at a stable rate. The adjustment mechanism usually provided by exchange-rate movements could instead be delivered by wage changes. It is only in more sluggish industrial economies, where wages are assumed to be inflexible, that policymakers advocate exchange-rate movements as a means to overcome wage stickiness.

However, in rapidly growing emerging markets, wages are often sufficiently flexible on the upside. For example, if an employer (particularly an exporter) fears future yuan appreciation, he may hesitate to raise wages in line with productivity increases, in order to keep his costs under control. However, if he can be confident that the exchange rate will remain stable, he will not need to restrain wages — and China has experienced 10 percent to 15 percent annual wage growth already. With faster wage growth at a stable nominal exchange rate and by encouraging unit labor costs to converge to those in developed economies, China’s real international competitiveness would be better calibrated.

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