China’s Rigid Currency Policy Threatens Growth

Eswar Prasad, Senior Fellow at Brookings, writing for the WSJ June 2011:


China’s currency regime is now beginning to look more like political dogma rather than sound policy. The rigid policy threatens to upset the delicate balance between keeping growth strong and inflation at moderate levels.

(…) In this scenario, a significant currency appreciation would serve the dual objectives of tamping down inflation and helping to shift the balance of growth toward private consumption. A more flexible currency would also give the central bank a freer hand in changing interest rates. A rising yuan would raise the purchasing power of domestic households, first directly through the fall in the price of imported goods and second by giving the central bank room to raise deposit rates, so that households get a better rate of return on their savings.

Yes, there has been some apparent progress on the currency front. Much was made of last June’s announcement by Beijing that it would let the yuan slowly appreciate. Over the past year, the yuan has appreciated by about 5% against the dollar, or about 7% to 8% in inflation-adjusted terms. But if we consider that the dollar has been in broad retreat against other major currencies, the yuan’s trade-weighted multilateral exchange rate—which determines its overall export competitiveness—has been relatively flat. This has kept pressure on the currency to appreciate.

And China’s central bank continues to intervene massively in foreign exchange markets to keep the yuan’s value stable, suggesting the currency is still significantly undervalued. Such intervention boosts the stock of international reserves by about $200 billion each quarter, adding to the government’s headache as this inevitably means more purchases of U.S. treasuries.

Beijing can avoid this headache if it frees up the yuan-dollar rate. Given the direction the dollar is headed, China could easily allow its currency to appreciate more without losing much in terms of its overall export competitiveness.

The mantra that a significant shift in currency policy is in China’s own interest is now truer than ever. Policy makers should realize that the impact of inflation could be much worse for overall growth: Once the inflation genie escapes from its bottle, the sort of drastic policy actions that will be needed to cool things off will hurt the economy a lot more than a few lost jobs in the exporting sector now.

(via Instapaper)