China’s remarkable growth has been financed recently by a rapid expansion of money and bank credit that is producing an increasingly unsustainable investment boom. This renews concerns that the country may not be able to avert a replay of the painful boom–and-bust cycle such as the one it endured in the mid-1990’s.
Monetary policy is usually the first line of defense in such situations. But China’s monetary policy has been hamstrung by the tightly managed exchange-rate regime. This regime prevents the central bank – the People’s Bank of China (PBC) – from taking appropriate policy decisions to manage domestic demand, because interest-rate hikes could encourage capital inflows and put further pressure on the exchange rate.
There is, of course, a vigorous ongoing debate about China’s exchange-rate policy. China’s rising trade surplus has led some observers to call for a revaluation of the renminbi to correct what they see as an unfair competitive advantage that China maintains in international markets. Others argue that the stable exchange rate fosters macroeconomic stability in China. But this debate misses the point.
What China really needs is a truly independent monetary policy oriented to domestic objectives. This would enable the PBC to manage domestic demand by allowing interest rates to rise in order to rein in credit growth and deter reckless investment. An independent monetary policy requires a flexible exchange rate, not a revaluation. But what could take the place of the stable exchange rate as an anchor for monetary policy and for tying down inflation expectations?