Apparently, the industrial world is becoming increasingly concerned about China’s currency policy.  The International Monetary Fund has just released a paper explaining why a fluctuating Chinese currency is in that country’s own best interest.  China currency reforms will be a major agenda item at the next G-7 meeting of major industrial countries. 

Why should China’s currency policy concern us, and why are the concerns more intense now than even a year ago?

For years, the Chinese bought or sold yuan in the foreign exchange markets in an effort to preserve a fixed rate of exchange against their yuan and our dollar.  A few years ago, there was fear that China did not have enough foreign exchange to support the yuan.  However, a surge of $206 billion in additional foreign exchange balances held by China in the past twelve months indicates that the tables have turned.

A currency whose value is fixed to another might create financial credibility.  However, one cost is loss of control over domestic monetary policy.  The country’s liquidity must expand or contract to preserve the currency ratio and cannot also be changed to stimulate employment or restrain inflation. 

Not surprisingly, the IMF paper indicated that China could regain control over its own monetary policy by allowing its currency to freely fluctuate in the foreign exchange markets.  Thus, attempts to restrain commodity inflation and slow economic growth (two goals of the Chinese government) would be improved after the yuan’s price fixing to the dollar is abandoned. 

When all currencies were fixed through a set price with a commodity, usually gold, global economic imbalances could only be removed through the impact that changes in foreign exchange balances had upon local liquidity.  Countries with large inflows of foreign exchange, such as China, would experience significant gains in liquidity as their balances grew, leading to domestic inflation.  Countries losing foreign exchange would suffer monetary restraint, causing prices to fall (usually after a recession has begun). 

While no one desired to have a recession or inflation dictated through foreign exchange flows, the fixed system worked when world imbalances were small.  As economic historians know, when Great Britain re-established a fixed exchange rate in the mid-1920s, the distortions from an incorrect rate no longer were small. The ensuing recessions (coupled with poor macroeconomic policies) led to world depression. 

China’s $206 billion one year increase in foreign exchange balances to a total of more than $600 billion no longer is small.  Basic manufacturing in the U.S. and Europe is battling recession tendencies.  The excess world liquidity required for this effort already has created commodity price inflation and may be contributing to global excesses in real estate pricing. 

While deflation has vanished from China, the subsequent inflation remains mild (about a percentage point higher than in the U.S.)  If we wait for differential costs to remove the imbalances, the current pace of Chinese inflation would require 40 years to restore global balance.  By that time, all the quaint villages in the French, Italian, Austrian, German and Swiss Alps would have long since lost their manufacturing base.  American mill towns will be nearly ghost towns.

Why is the fixed exchange rate between China and the U.S. not adjusting as rapidly as such conditions did in the past?

Half the explanation is the Chinese banking system.  During the period of collectivization, very large government enterprises were created and many still exist.  They are woefully inefficient and need government subsidies.  In the past, these subsidies have been indirect, through credits from the banking system.  Thus, Chinese bank capital is tainted by these bad government debts that cannot be written off. 

The Chinese are rebuilding bank capital and hoping that normal banking functions can be performed by existing banks.  (National pride, as in Japan, prevents the Chinese from the obvious solution of partnering with international financial institutions to create a strong domestic financial structure.)

In the meantime, the liquidity created from foreign exchange is only partially flowing into the domestic Chinese economy.  Instead, the balances are being reinvested in international financial assets (much of which are 10 year U.S. government bonds.)  Thus, the lost U.S. foreign exchange is being returned to us, but at interest. 

Eventually, the Chinese foreign exchange balances will become so large that only a serious currency adjustment or massive world liquidity shifts, and resulting economic dislocations, will resolve the imbalances.  A few economists don’t want that to happen.  If only our Treasury and the Chinese  would realize the urgency of removing this imbalance through flexible currency fluctuations (or does the Bush administration want those Chinese purchases of U.S. bonds in order to limit the current cost of government programs?)