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.

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?