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Complex issues in Chinese currency and exchange rates

Second comments on Yiping Huang “Misperceptions about the RMB and Chinese exchange rate policy”, 11/04/2010, http://www.eastasiaforum.org/2010/04/11/misperceptions-about-the-rmb-and-chinese-exchange-rate-policy/

There are a number of points relevant but missing in Yiping's analysis.

Firstly, the impact on employment of appreciation, especially on mobile workers from rural areas and associated social stability must be carefully analysed and considered. This, of course is what the authority has to consider when large scale closures of manufacturing plants as a consequence of currency appreciation are concerned.

It is not just an issue static versus dynamic adjustment issue, although it has some relevance. Any dynamic adjustment has to be realistic as opposed economists’ wishes for a sudden technical or management improvement. For economists, it is so easy to change the ratio of labour versus capital and adopt new technologies. But in reality, the story can be quite different. Managers and entrepreneurs are not as lazy as some economists think.

Secondly, the issue of China's official reserves and assets denominated in $US and its potential very damaging consequences in terms of social stability, given that now many Chinese are aware the effects of a yuan appreciation. It is obvious to so many Chinese, especially the so called elite what an appreciation means in terms of the values of those assets. It is, however, very difficult to judge the how the public will react to authority sanctioned appreciation and the losses in state assets values.

Thirdly, even China adopted a flexible exchange rate, there is no guarantee that the US or some others continue to pressure China. For example, they could and would argue that it is not flexible enough as long as they wish to use it as stick to achieve whatever purpose they may have. At some stage, a country has to stand up to powerful countries for its own interests, otherwise international bullies will repeat endlessly with no real prospect to be checked.

Fourthly, the argument of country can only achieve two out three goals of "monetary policy independence, the free flow of capital and exchange rate stability" is likely to be problematic, if bank credits can be controlled. It is more than likely that in China’s case, all three can be achieved, rather than the conventional view.

Fifthly, although Yiping used some of the key insights (the unholy trinity) from the Mundell-Fleming model of international trade, an important implication of the model is overlooked, that is, the differential growth in domestic income as compared to external income. That should mean a deterioration of the current account balance. The experience of the past months indicates that has been the case now and further and possibly increasing trade deficits are likely to occur.

It would be prudent for both China and the US and other players to wait and assess the development in recent months before making any unwise moves. The Chinese economy is at a critical stage of structural transformation and in the short term it is highly likely to experience current account deficits until the transformation is completed.

Yes, China may move back to pegging to a basket of currencies and allows reasonable flexibility, but it does not necessarily mean currency appreciation measured by trade weighting.

Now it leads to ma last point on the missing elements in Yiping’s article, that is, the issue of China’s official holdings of $US denominated assets, that so many analysts have either ignored or think difficult to deal with.

It should be abundantly clear that it is reasonable for the Chinese authority to negotiate with the US authority on the issue of Chinese holdings of the US Treasury bonds. In fact it would be negligent of duty if the Chinese authority does not deal with this issue. Some move on that front is necessary for the Chinese authority to be able to tell its domestic audience on any currency moves.

It is unreasonable and indeed irrational for the US to ask for China to appreciate its currency and make a direct loss by holding the US government bonds. That will make the Chinese authority look so stupid.

A reasonable compromise is to use a mixed currency denomination, e.g. denominated in a basket of currencies.

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