Recently the Chinese authorities announced an end to the dollar peg and a move towards a more flexible exchange rate, as commented upon in a previous post. However, there are fears among Chinese officials that this could lead to a wide range of problems, including speculation and hot money inflows, as well as undermining the Chinese growth strategy.
Problems related to U.S.—Asian exchange rates are not new though, and serve as a perfect illustration of the manifold problems related to government’s monetary management, both on a domestic and international level.
Domestically, currency management relates to central bank’s desires to govern the macro-economy through controlling short-term interest rates by injecting liquidity into the banking sector to stimulate growth or, conversely, draining it to cool down the economy. This is done by interventions in domestic financial markets through so-called open market operations, in which the Fed buys or sells assets through money creation or destruction. Internationally, currency management relates to market interventions or diplomatic pressure to influence exchange rates.
Usually the authorities have to choose one or the other. In the U.S. the Federal Reserve conducts monetary policy with an eye to domestic policy goals—aiming at a certain level of prices, output and employment. However, the Fed’s interest rate decisions affect more than just the domestic economy; it also affects the functioning of the global monetary and financial system.
Low interest rates in the U.S. put downward pressure on interest rates world-wide for several reasons. If other country’s central banks keep their interest rates significantly higher than the U.S. policy rate, this will attract money flows, driving up the value of their currencies, thus reducing their economy’s competitiveness. Moreover, when keeping interest rates low the Fed injects liquidity into global financial markets, pulling down long-term interest rates worldwide.
Across the Pacific, the People’s Bank of China seeks to maintain a certain exchange rate by actively intervening in currency markets, buying dollars to keep the renminbi, the Chinese currency, from appreciating. This has led to immense holdings of currency reserves and massive capital flows into the U.S. economy, something which contributed to the unsustainable financial bubble of the 2000s and which now fuels profligate spending by the U.S. government.
During the last decade, the U.S. has put diplomatic pressure on the Chinese government to let their currency appreciate against the dollar, thus increasing U.S. competitiveness vis-à-vis China and reducing the trade deficit. Senator Charles Schumer (NY-D) has threatened the Chinese authorities with tariffs if they don’t let the renminbi appreciate. This line of action is endorsed, among others, by Paul Krugman.
However, the Chinese are playing it cool for several reasons.
One major concern is to avoid the fate of Japan. In 1985, the U.S. put pressure on the Japanese government to let the yen appreciate. The agreement—known as the Plaza Accord—was followed by rapid appreciation, significant loss of Japanese competitiveness and an economic slump. It was the beginning of the end of Japan’s high-growth period.
China is worried that the same could happen to the renminbi, hurting the Chinese growth strategy of exporting cheap manufactures to the industrial countries, especially the U.S.
Also, Chinese officials fear a similar fast-track appreciation as happened with the yen. If speculators expect the currency to steadily appreciate, this could lead to rapid inflows of money, driving up the value of the currency further and at a faster rate. As reported by the Financial Times:
“The problem for policymakers is that most investors believe that the renminbi is significantly undervalued against the dollar—some even estimate by almost as much as 50 per cent. So speculating on a revaluation is widely seen as a one-way bet.”
Speculative capital flows into China could in turn lead to asset bubbles and undermine the central bank’s monetary control. In order to avoid this scenario, the authorities have resorted to a strategy of making the exchange rate unpredictable; It could go both up and down.
These worries—about competitiveness, growth strategies and instable capital flows—are a perfect illustration of the perils of monetary management.
Benn Steil of the Council of Foreign Relations co-authored a book last year on the problems of “monetary sovereignty”—how national governments issue competing currencies and conduct independent monetary policy in attempts at managing their economies or the economic relations with other economies. The main message is that this kind of monetary system is incompatible with globalization and leads to a highly unstable international financial system.