China’s Exchange-Rate Trap

NEW YORK – For months now, China’s exchange-rate policy has been roiling global financial markets. More precisely, confusion about that policy has been roiling the markets. Chinese officials have done a poor job communicating their intentions, encouraging the belief that they don’t know what they’re doing.

But criticizing Chinese policy is easier than offering constructive advice. The fact is that China’s government no longer has any good options. No question, the country would be better off with a more flexible exchange rate that eliminated one-way bets for speculators and acted as an economic shock absorber. But the literature on “exit strategies” – on how to replace a currency peg with a more flexible exchange rate – makes clear that the moment when China could have navigated this transition smoothly has now passed.

Countries can exit a pegged rate smoothly only when there is confidence in the economy, encouraging the belief that the more flexible exchange rate can appreciate as well as weaken. This may have been true of China once; it is no longer true today.

This puts Chinese policymakers in the position of the Irish tourist who asks for directions to Dublin and is told, “Well, sir, if I were you, I wouldn’t start from here.”