China also holds foreign
currency reserves of over a trillion
USD, most of it in dollars. If it were to
shift away from the dollar, the
greenback would devalue
dramatically.
Should the Chinese government
allow the Yuan to appreciate to reduce
global trade imbalances?
At least in the short-run, I recommend
the Chinese government to keep the
Renminbi within a narrow trading
band with reference to a basket of the
currencies of its major trading
partners for political and economic
reasons. Let me explain.
The boom in Chinese net exports
increased the demand for Chinese
currency to pay for them.
Macroeconomists conceptualize this
change as an exogenous shift in
demand that moves the economy
away from equilibrium. Since the
Chinese government de facto keeps its
currency in a narrow trading band
with the US dollar, markets do not
clear. The country accumulates a large
trade surplus with the US and huge
foreign currency reserve, since it has
to purchase US dollar denominated
government bonds to keep the
greenback strong. Neoclassical
economists trust in an easy solution to
restore equilibrium: They believe that
if the exchange rate were fully flexible,
the Chinese Yuan would appreciate
and net exports decrease until a new
equilibrium is reached.
However, the neoclassical model
assumes perfectly competitive
markets. With idealized features like
unlimited numbers of buyers and
sellers, perfect information, no
government interference and, to top it
all, rationally thinking people, those
are a rare species in the real world!
I will first argue against the
theoretical orthodoxy on purely
macroeconomic grounds and then
move to the political economy. It is
possible that a flexible exchange rate,
at least in the short-run, will not clear
markets and may even lead to new
types of imbalances. For example,
faced with an appreciating currency,
Chinese exporters may simply allow
their margins to be squeezed to keep
their prices low. How long they can
maintain such a strategy depends on
their financial "slack" in terms of
economic rents and reserves. If the
government supports them, they may
be able to keep in business
indefinitely. Besides, the demand for
Chinese exports might not
immediately decrease when they
become more expensive. The priceelasticity
of demand might be
relatively low at least in the short run.
It might be very difficult for major
importers to locate alternative sources
that can supply the high volumes they
need. Besides, currency speculators
may move the Yuan away from the
elusive "scientifically" correct level,
INTERVIEW 5
which accurately reflects the forces of
supply and demand in the real
economy and clears the markets. The
resulting exchange rate may distort
resource allocation, as witnessed in
the Asian Financial Crisis, when even
the efficient Singapore economy was
hit hard.
Even if markets were to clear
eventually, the transition might come
at huge costs: High uncertainty and
instability. I believe that politics is the
most important factor driving
economic development and that
volatility is expensive. In an
increasingly complex and uncertain
world, a government needs more
national control, not less. The reason
for China's success in the past was
that it had structures, systems and
processes in place that allowed the
government to manage events. Thus,
it avoided significant damage from the
Asian Financial Crisis, whereas the
governments in other countries that
had put less controls in place suffered
dramatically. To continue its success,
China must remain in charge of
developments.
Besides, many people spend large
sums of money on premiums to insure
against risk, which are a good measure
of its costs. Alas, one cannot even
insure against uncertain events, since
in contrast to risk, it is impossible to
specify the full range of different
outcomes in advance and
probabilities cannot be calculated.
The political stability resulting from
narrow currency trade bands is a
certain gain, whereas flexible rates
surely introduce uncertainty without
assured benefits. Any future changes
to the currency regime should only be
made after small-scale experiments
have yielded positive results. A shock
therapy like in Russia can easily lead
to national collapse.
It is also important to mention that
contrary to popular opinion, a flexible
Yuan most likely is not even in the
national interest of the US. To start
with, the shift will immediately favor
one group and put another groups at a
disadvantage. The aggressive call for a
freely floating Yuan originated from
special interest groups, in this case
lobbyists from those industries in the
US that are hit hard by Chinese
exports. Reacting to the forces at work
and incentives in a democratic
system, US career politicians resorted
to pork barrel tactics. They backed the
policy demands of the pressure
groups to please voters and donors.
The policy would never have been
recommended by an individual
neutral planner intent on maximizing
the gains of the nation as a whole. A
significant share of Chinese exports
comes from foreign companies,
including many multinational
companies from the US. If the Chinese
currency appreciates, they are likely
to lose. Besides, imports would
become more expensive in the US,
possibly fueling inflation.
