Why Worry About China’s Exchange Rate?

The analogy is not quite right, but TH reckons that Mental As Anything’s tune … “If you leave me can I come too?” might be appropriate for this blog.

On that note … there is an awful lot of fuss about China’s exchange rate. China has generally pegged against the USD for a long time now — and the US has not been able to shake its adoring partner, no matter how hard it has protested. 

Anyway, this peg was considered a determinant of unsustainable current account positions in the lead up to the GFC.  But surely with China’s current account having fallen from 10 percent of GDP (clearly an imbalance?) to just 2.5 percent of GDP (clearly not?) that issue is now moot. China’s exchange rate is about right. Right?

There are two problems. First, China is soon to overtake the US and  become the world’s largest economy.  According to the IMF WEO, that happens in 2017.  That is not far away.  And for the US, it makes it really challenging to implement monetary policy when the worlds soon to be largest economy is ruthlessly pegging its exchnage rate to yours.  Its a bit like trying to tie you shoe laces when one of your laces is also tied to someone elses shoes. 

Second, the overall value of China’s currency might be right relative to the world, but it might not be right relative to the US dollar, against which China pegs. Economists generally speaking don’t have good models to examine how systems of large countries adjsut when there is a mix of countries with fixed and flexible currencies.  But suffice it to say, that the peg of the Chinese yuan against of the USD may be causing China to adjust differently against the US versus against other emerging economies or the Euro.  This can itself lead to imbalances that are not well understood, but should not be ignored.  Especially when the economy that is pegged to the US is about to become the world’s largest.



One thought on “Why Worry About China’s Exchange Rate?

  1. Torrens,

    Good post. Good analogy. I suspect that the Chinese are aware of certain “contradictions” that are looming ahead. That is why they have accelerated efforts to internationalize the RMB. The question is how successful will these efforts be as long as there is residual uncertainty about legal frameworks (rule of law, contract enforcement) and the politics (and policy process) remains opaque.

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