By McKinnon, Ronald I.
The International Economy , Vol. 24, No. 4
China is again coming under heavy political pressure by the U.S. government to appreciate the renminbi, with some European officials chiming in. Behind this political clamor is the academic view of many economists that exchange rate "flexibility" is itself desirable--particularly as a way of correcting imbalances in foreign trade. Bowing to this foreign pressure, the People's Bank of China announced on June 19, 2010, that it was unhooking its two-year old peg of [yen]6.83 per dollar and would henceforth be more flexible. But since then, the yuan/dollar rate has moved very little. The rate by mid-September rate was just [yen]6.73 dollar. Outraged, American and European politicians sense that they were deceived.
But China's government is trapped in two important respects.
First, government officials and many economists on both sides are in thrall to a false theory: that a discrete appreciation of the renminbi against the dollar would have the predictable effect of reducing China's trade surplus and the U.S. trade deficit. Once one realizes that China's trade surplus just reflects its net surplus of saving over investment, and vice versa for the saving-deficient United States, then there is no presumption as to which way savings-to-investment would move if the renminbi was appreciated. True, an appreciation would reduce China's corporate profitability and some corporate saving. However, in our globalized financial system, investment would fall sharply when China was suddenly seen to be a more expensive country in which to install productive capacity and produce from it. And China's current extremely high ratio of investment to GDP, about 40 to 45 percent, has a long way to fall. With the greater sensitivity of investment to the exchange rate, any presumption should be that China's trade (net saving surplus) would increase with renminbi appreciation
Second is the issue of exchange rate flexibility in itself. It is impossible for the People's Bank of China to withdraw from the foreign exchange market and let the "market" decide what the rate should be when at the same time it has a huge net saving (trade) surplus. Many well-meaning foreign commentators, who are not overtly bashing China to appreciate its currency, still believe that greater market-determined exchange flexibility is warranted. U.S. Treasury Secretary Timothy Geithner seems to think so:
"It is China's decision about what to do with the exchange rate--they're a sovereign country, " Geithner said. "But I think it is enormously in their interest to move, over time, to let the exchange rate reflect market forces, and I am confident that they will do what is in their interest," he said while visiting Boeing and other exporters in Washington State.--Associated Press, May 23, 2010
Secretary Geithner's tone here is much more measured and careful than in previous episodes of American China bashing, where various congressmen, journalists, industrialists, union officials, and economists have called for a large appreciation of the renminbi against the dollar. Nevertheless, Secretary Geithner's more moderate and seemingly reasonable approach to letting the yuan/dollar rate reflect "market forces" by floating or otherwise becoming more flexible is still not feasible. Why?
CHINA AS AN IMMATURE INTERNATIONAL CREDITOR
China is in the historically unusual position of being an immature creditor: its own currency, the renminbi, is hardly used at all in financing its huge trade (saving) surplus. Instead, the world--particularly the Asian part of it--is still on a dollar standard. The dollar is the invoice currency of choice for most Chinese exports and imports and for open-market, that is, nongovernment, controlled financial flows. So we have the anomaly that the world's largest creditor country cannot use its own currency to finance foreign investments.
The lag in the international use of the renminbi is partly because China's domestic financial markets are not fully developed. …