THE CHINA CURRENCY SYNDROME / THE WALL STREET JOURNAL REVIEW & OUTLOOK ( A MUST READ )

REVIEW & OUTLOOK

JUNE 21, 2010.

The China Currency Syndrome

World leaders would do better to worry less about imbalances and more about whether their own nations are pursuing policies that contribute to global prosperity.


The best that can be said for China's weekend decision to drop its dollar peg and again adopt more "exchange-rate flexibility" is that it may avert a trade war. What no one should believe is that China's move will "rebalance" the world economy or send manufacturing jobs rushing back to America.

The People's Bank of China asserted that its decision was made in China's own economic interests, and no doubt that's true. But its timing a week before the Group of 20 meeting in Toronto is no coincidence, comrade. China did not want its exchange rate to become the conclave's focus, diverting attention from the failures of U.S. and European economic policies.

Senator Chuck Schumer and other U.S. protectionists have also been promising a new tariff against Chinese goods if Beijing didn't move on the exchange rate. And this time the New York Democrat seemed to have corralled such key party colleagues as Max Baucus, chairman of Senate Finance, and Sander Levin of House Ways and Means as his Smoot and Hawley.

Given the Democratic panic about their November election prospects and President Obama's ebbing political authority, a protectionist mistake from the U.S. Congress cannot be ruled out. China's move reduces the odds of such a blunder, at least in the short run, and that should help the fragile world recovery.

We say "short run" because China's decision won't end the global demands for a revalued yuan. The People's Bank of China statement made clear that a big one-time revaluation is not in the offing, and the band in which the currency trades daily will not be widened. U.S. Treasury Secretary Timothy Geithner immediately responded that China's move "is an important step but the test is how far and how fast they let the currency appreciate." Mr. Schumer demanded even more aggressive revaluation and said he'll still try to move an anti-China trade bill.

Beijing knows that yuan volatility will only hurt its domestic exporters, the main driver of employment, and deter the kind of stable, long-term foreign investment it wants to attract. So a "flexible" exchange rate probably means a managed crawl, akin to the policy that let the yuan appreciate by some 21% against the dollar from 2005 until the financial panic hit in 2008. However, the expectation of a gradually stronger yuan will only invite more global "hot money" betting on further yuan appreciation.

These capital inflows have made it increasingly difficult for Chinese monetary authorities to control both the exchange rate and domestic inflation. So has the U.S. Federal Reserve's extraordinarily loose monetary policy, which shows no signs of changing and is producing price bubbles in Asia, notably in Chinese property. The decision to unpeg the yuan from the dollar frees China's central bank to pursue a monetary policy independent of the Federal Reserve and thus reduce the risks of imported inflation.

On the other hand, China's central bank will have to continue its accumulation of dollar assets, which it will then recycle around the world into the likes of U.S. Treasury bonds. A better solution would be to make the yuan more convertible and give private market actors more influence over trade and capital flows, rather than depending on the central bank. But that won't happen until the Communist Party agrees to depoliticize the allocation of credit and give more power to private citizens. The political irony is that China's rulers prefer the West's preoccupation with the exchange rate, which is easier to accommodate, rather than having to undertake more fundamental reform.

Another illusion is that a revalued yuan will reduce global "imbalances" and especially the U.S. trade deficit. The 2005-2008 revaluation did little to move the trade numbers. And as Stanford economist Ron McKinnon has documented, the U.S. forced a similar revaluation on Japan in the 1990s, and the result was little long-term change in the trade deficit between the two countries.

To the extent that a revalued yuan raises production costs in China, some of its manufacturing will move to Vietnam, Bangladesh or other lower-cost countries. Meanwhile, U.S. consumers will pay more for imported goods, and Chinese producers will be forced to become even more competitive and thus a bigger global challenge to U.S. companies.

As for the U.S., the yuan has become a convenient scapegoat for Washington's policy mistakes. The neo-Keynesians who've been running U.S. economic policy since 2007 promised that their stimulus would deliver millions of new jobs. Now that those jobs have failed to materialize, Democrats blame China's exchange-rate policy. But no country in history has devalued its way to prosperity, and the U.S. won't be the first.

The dollar has benefitted in recent months from the investor flight to safety amid the European sovereign debt panic. This has masked the risks to the dollar from the easiest Federal Reserve policy in modern history. Those risks will accelerate if the panic eases and investors look once again to protect themselves against the dollar's decline. One by-product of the last period of yuan revaluation (and dollar decline) was a spike in the price of global commodities traded in dollars. Another such spike would not help global growth.

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The pursuit of some ideal global "balance" in trade and capital flows is an illusion of IMF officials and other central planners. World leaders would do better to worry less about imbalances and more about whether their own nations are pursuing policies that contribute to global prosperity. In the U.S. and Europe, that means a major policy turn toward spending restraint, lower taxes, freer trade and less political control of business.

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