2008-01-13

Currency Peg Meets Reality

James Fallows has a good article on the gigantic imbalance between the American and Chinese economies:
Through the quarter-century in which China has been opening to world trade, Chinese leaders have deliberately held down living standards for their own people and propped them up in the United States. This is the real meaning of the vast trade surplus—$1.4 trillion and counting, going up by about $1 billion per day—that the Chinese government has mostly parked in U.S. Treasury notes. In effect, every person in the (rich) United States has over the past 10 years or so borrowed about $4,000 from someone in the (poor) People’s Republic of China. Like so many imbalances in economics, this one can’t go on indefinitely, and therefore won’t. But the way it ends—suddenly versus gradually, for predictable reasons versus during a panic—will make an enormous difference to the U.S. and Chinese economies over the next few years, to say nothing of bystanders in Europe and elsewhere.

This paragraph is explains how China's currency policy helps Americans. By artificially lowering the value of its currency, China engages in wealth transfer from poor Chinese to rich Americans. However, as with all artificial market manipulations, eventually the state is unable to continue defying market forces. China's inflation rate is growing faster than the American inflation rate. China's monetary policy has been inflationary and in the long-run, had they kept the peg, China's currency would have declined to the rate of the peg.

As China revalues its currency though, it will shift inflation from itself to the United States (just as the U.S. was able to hold inflation low thanks to the PBOC's policy), assuming the dollars return to the U.S. and do not end up in another foreign central bank.

One cannot evaluate China's reserves, however, without considering its financial sector debt. Steven Hanke discussed China's reserves in 2005:
There's no denying that $769 billion is a big number. But still--and here's another surprise for my friendly congressman--it's not big enough. China must have reserves to accommodate routine foreign transactions. Taking into account the size of the Chinese economy, its money supply and its imports, I estimate these to be $455 billion. In addition, it needs reserves for exigencies beyond normal transactions. Now that the U.S. is demanding a wholesale opening of China's financial sector, China will have to fill in the sinkhole of bad loans that threaten to undermine its banking system. This task, now under way on a timid scale, is ultimately going to cost perhaps $650 billion.
To complete a wholesale opening of the financial sector, China will also have to make the yuan convertible. This will require at least another $200 billion. Add it all up, and you have needs for foreign reserves in the neighborhood of $1.3 trillion. It's only halfway there. Stop complaining.

If Hanke is right, China now has the financial reserves it needs to complete its financial reforms—which means it also has the ability to unwind the reserves. Read James Fallow's article to get a sense of what a change would mean.

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