US Federal Reserve officials are not optimistic that China will drop its currency peg against the dollar anytime soon because that decision is in the hands of a State Council focused primarily on political stability rather than financial issues.
The State Council apparently believes that China's political stability hinges on continued strong economic growth which will provide the tens of millions of new jobs needed by workers moving out of agriculture and into the industrial economy. And that growth in turn is seen as dependent on keeping the yuan pegged tightly to the US dollar.
Fed chairman Alan Greenspan has said that keeping the yuan pegged to the dollar means that the People's Bank of China, the country's central bank, cannot control the country's money supply. As a result, mounting inflationary pressures eventually will force a revaluation of the yuan, he says.
At the same time, keeping the peg has forced the central bank to accumulate well over half a trillion dollars worth of foreign exchange reserves, mostly US dollars.
And the exploding US trade deficit with China is generating increasing protectionist pressure in the United States. The Commerce Department said on Thursday the trade deficit with China was US$162bil last year. That is more than double the US$75bil deficit with Japan or the US$72bil deficit with the members of the Organisation of Petroleum Exporting Countries.
China's central bank officials are acutely aware of all these issues. In a sense, though, they are advisers to the decision makers on the State Council, a political body, and that leaves the timetable up in the air for any easing of the dollar peg. That worries some at the Fed.
At a symposium at the San Francisco Federal Reserve Bank last week, more than 30 economists, mostly from universities and international institutions, tackled the issue of China's currency peg. Most of them argued that China would be forced to adopt a more flexible exchange rate regime, and some said that would come no later than next year.
On the other hand, the symposium – which was titled, “The Revived Bretton Woods System; A New Paradigm for Asian Development?'' – was called to discuss a series of papers by economists who maintain that the Chinese have such an overriding interest in strong growth that the peg will last at least for another five years.
Economist Peter Garber, global strategist for Deutsche Bank, one of the papers' authors, told the group: “I don't think anybody disagrees that this eventually will come to an end.'' That probably will only happen “when the labour supply is absorbed,'' he said.
One of his co-authors, Michael Dooley of the University of California, Santa Cruz, said the peg would last “five years, or you could go a little further.''
The heart of the Dooley and Garber analysis – in which David Folkerts-Landau, another Deutsche Bank economist, has participated – is that the current situation in China and other East Asian countries resembles that of Western Europe in the 1950s after much of it was devastated by World War II.
Under the aegis of the Bretton Woods system of exchange rates fixed to the dollar, they said, the European countries enjoyed the trade advantages of undervalued exchange rates that allowed them to rebuild their stocks of productive capital. The authors described the United States as being the “centre'' of that system and Europe on the “periphery''.
Today, the United States is again the “centre'' with China and other East Asian countries on the ''periphery'', in their view.
No one at the symposium expressed support for the notion that the Chinese would be able to maintain their peg nearly as long as Dooley and Garber said they could. Nouriel Roubini of New York University was the most vociferous among those attacking Dooley and Garber's view.
“It's not sustainable and will unravel,'' Roubini said. “Once central banks signal less willingness to finance,’’ that will trigger a massive private investor rush out of the dollar.
Edwin M. (Ted) Truman, a senior fellow at the Institute for International Economics and former head of the Fed Board's Division of International Finance, referred to the papers as “musings'' and said their “view is incorrect and their framework does not provide a useful guide for analysis or policy''.
“A continuation of a US current account deficit of 6% of GDP is neither economically, financially nor politically sustainable,'' Truman said. “The large economies with more or less firm pegs to the dollar inevitably will have to be part of the adjustment process.''
Other attendees noted that even if Dooley and Garber had correctly described the new system, it is breaking down. Several other countries assumed to be part of the periphery, including South Korea, Thailand, Singapore and Taiwan, have all allowed their currencies to appreciate against the US dollar beginning last fall.
Ronald McKinnon of Stanford University challenged Dooley and Garber, and most of their critics as well, with an intriguing proposition.
“Exchange rate changes are not the answer to American trade deficits and Asian trade surpluses,'' McKinnon said. Instead, China should keep its peg and let the long run international adjustment occur by allowing its wages to rise in line with its extremely high productivity growth. That process, he added, was already happening. – Bloomberg