Sunday, April 25, 2010

Chinese exchange rate flexibility would affect the US

Published in The Tennessean, April 25, 2010

Chinese exchange rate flexibility would affect the US

by Richard J. Grant

Why did Treasury Secretary Timothy Geithner decide to delay a regularly scheduled report on international monetary policies? Apparently the report accused China of being a “currency manipulator.”

Such accusations do not make for easy relations, but they are made to achieve a purpose. Speaking before a congressional committee, Federal Reserve Chairman Ben Bernanke claimed that the yuan is “undervalued” and hinted that the Chinese do this deliberately in order to promote exports. He suggested that the Chinese should allow more flexibility in their exchange rate to “address inflation and bubbles within their own economy.”

Whatever faults the Chinese might have in their economic policies, accusations of currency manipulation are misleading. Most of the time since 1997, China has had a fixed exchange rate policy. Although from 2005 to mid-2008 the yuan was allowed gradually to appreciate, since July of 2008 it has been pegged at about 6.83 yuan per dollar.

As a policy choice, a fixed exchange rate is quite respectable. For the quarter century following World War II, the international monetary system was built on fixed exchange rates. Most currencies were fixed to the US dollar, which was fixed to gold.

That system ended for much the same reasons that could cause the yuan soon to float against the dollar. Many countries inflate their currencies for domestic political gain. By inflating the currency, short-term interest rates can be held down during politically important time periods. Also, inflation of the money supply weakens the currency relative to other currencies thereby giving a temporary advantage to domestic export industries, albeit at the expense of domestic importers.

This can lead to periods during which several countries are trying to compete by weakening their currencies. But this is a race to the bottom in which the "loser" appears to have the strongest currency.

Of course, any country that plays this game will have a weak currency compared to the values of real goods. Inflated currencies can appear strong only when compared to currencies that are weaker.

The postwar Bretton Woods monetary system of fixed exchange rates eventually broke down, not because other countries were inflating (though many were), but because the United States inflated the quantity of dollars beyond the value of its gold reserves. In other words, our monetary authorities failed to keep the dollar sufficiently backed by gold; and as a result, foreign central banks began to redeem large amounts of dollars for bullion. On being advised that we would have to either increase the official gold price or run out of gold reserves, President Richard Nixon decided to put an end to all gold redemptions.

Before August 1971, the dollar had always been defined as some quantity of gold. Since then, the dollar has been adrift, and it should have been no surprise that in the decade that followed, US price inflation rose as high as 14 percent. Interest rates went even higher.

Inflation was eventually brought down to low levels, and some countries have chosen to fix their currencies to the dollar. China is one of those countries, but there are at least two reasons why China is likely to allow its currency to appreciate relative to the dollar. The recent expansion of the US money supply threatens to cause price inflation in China; and US trade protectionists are exerting political pressure to demand that China appreciate the yuan.

This could precipitate at least a mild slowdown in China, though it won't be as bad as it would be if they were to delay. But here in the US, the result will be an earlier manifestation of increased price inflation and greater pressure on the Fed to raise its target interest rate.

If it must happen, the administration would want the Chinese to do it either before June or after November. They want the imagined protectionist benefit, but wish to avoid any disruptions just before the midterm elections.

Richard J. Grant is a professor of finance and economics at Lipscomb University and a scholar at the Tennessee Center for Policy Research. His column appears on Sundays. E-mail:

Copyright © Richard J Grant 2010