When Should China Float?

Under heavy pressure from America, China's leaders have agreed in principle to float the renminbi, but refuse to say when. A floating currency is inevitable as China liberalizes its capital market and eliminates restrictions on international capital movements; otherwise, China would have to surrender control over its money supply and interest rates to the US. Yet China's rulers are right to postpone the decision to float.

The Chinese can delay, but they can't hide from a fundamental economic law: if the exchange rate between the currencies of two countries is fixed and capital flows between them are unrestricted, the economically dominant one will exercise control over the monetary policy of the other. Because the dollar is the dominant world reserve currency, and America's Fed controls the supply of US dollars, as long as China sticks to a fixed exchange rate, it cannot control its own money supply.

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The reason is simple. If China attempts to lower its money supply by raising interest rates, it will trigger a corresponding increase in demand for renminbi, as foreign capital seeks to take advantage of higher interest rates on Chinese assets. To maintain the fixed exchange rate the Chinese central bank would need to offset this by increasing the money supply--the opposite of what it set out to do in the first place. Similarly, any attempt to increase the money supply by lowering interest rates would fail as long as the exchange rate between the renminbi and dollar remains fixed.

Is this necessarily a problem? If America pursued a policy of price stability and China kept its exchange rate fixed to the dollar, wouldn't China have price stability as well, without worrying about its money supply, which would, in effect, be set by the Fed?

Perhaps, but only if the US did indeed pursue a policy of price stability and if China's economy were small enough for its domestic prices to be closely linked to the price levels of internationally traded goods. But China is a big economy, and will be bigger in the future. Moreover, America can't be trusted to pursue international price stability. So China cannot stabilize its economy by relying on US monetary policy.

The current conflict between China and the US recalls the breakdown of the Bretton Woods system of fixed exchange rates thirty years ago. The dollar was then officially a reserve currency, and the economically dominant US could determine its money supply independently of its external balance of payments.

This was not true of other countries. As international capital and credit markets grew and Europeans increasingly allowed capital to move freely, it became impossible for them to control their money supplies. As long as US policy supported stable prices in world markets, the system worked well, notwithstanding the asymmetry and built-in conflict over the control of monetary policy.

The situation changed in the late 1960's, when US monetary policy--loosened by the costly Vietnam War and domestic social programs--became inflationary. The rest of the world, particularly Germany, had no choice but to let their currencies float.

The architects of the Bretton Woods system tried to provide some safeguards against the unilateral opportunism America then exercised. The primary check was that other countries could demand conversion of their growing dollar reserves into gold at the fixed price of $35 per ounce.

This they did. In the decade after 1958, almost two thirds of overseas dollars were converted into gold. But this constraint proved futile. With US gold reserves depleted, President Nixon ended gold convertibility in August 1971. After the brief, unsuccessful attempt at exchange rate realignment known as the Smithsonian Agreement, the world's major currencies were floated in February 1973.

This monetary history is relevant because America is no more likely to accept international constraints on its monetary policy today than in the past. The Fed is not prepared to raise interest rates or tighten reserve requirements to restrain economic overheating in Shanghai. (For reasons too complicated to explain here, the possibility of China's converting its reserves from dollars to euros would be just as ineffective a constraint on US policy as the earlier threat of gold conversions.)

So China and the US are on a collision course, a replay of the Bretton Woods crisis. Barring an unlikely international agreement, China, like Germany in 1973, will have to let its currency float.

But the Chinese are right to play for time. It would be a mistake to float the renminbi under today's speculative and external political pressures. With the credibility of Chinese economic policy continuing to be based on the fixed exchange rate, any flotation must be part of a larger program of reform.

Revaluation upward, the inevitable result of floating the renminbi, would increase the burden of renminbi-denominated debt, making the balance sheet problems of Chinese banks and state-owned enterprise harder to correct. It is in nobody's interest to precipitate a financial crisis in China.

To avoid crisis, China must rein in excessive credit growth and the overheating that results from it. Although China will eventually lose its ability to control the supply of renminbi, because capital controls remain in place, China--unlike Germany's government in the early 1970's--can still control the supply of credit and inflow of foreign capital.

So, for now, China can bring monetary expansion under control while keeping the exchange rate fixed. Floating the renmimbi can--and should--wait until China's bank balance sheet problems have been addressed and its monetary system and capital markets become more developed and ready to play a stable role in global finance.