China’s financial conundrum and global imbalances

Ronald Mckinnon and Gunther Schnabl
1Professor of International Economics at Stanford University;
2Professor of International Economics at Leipzig University.

Abstract:
China’s financial conundrum arises from two sources: (1) its large trade (saving) surplus results in a currency mismatch because it is an immature creditor that cannot lend in its own currency. Instead foreign currency claims (largely dollars) build up within domestic financial institutions. And (2) economists – both American and Chinese – mistakenly attribute the surpluses to an undervalued renminbi. To placate the United States, the result is a gradual appreciation of the renminbi against the dollar of 6% or more per year. This predictable appreciation since 2004, and the fall in US interest rates since mid 2007, not only attracts hot money inflows but inhibits private capital outflows from financing China’s huge trade surplus. This one-way bet in the foreign exchange markets can no longer be offset by relatively low interest rates in China compared to the United States, as had been the case in 2005-06. Thus, the People’s Bank of China (PBOC) now must intervene heavily to prevent the renminbi from ratcheting upwards – and so becomes the country’s sole international financial intermediary.
Despite massive efforts by the PBOC to sterilize the monetary consequences of the reserve buildup, inflation in China
is increasing, with excess liquidity that spills over into the world economy. China has been transformed from a
deflationary force on American and European price levels into an inflationary one. Because of the currency mismatch,
floating the RMB is neither feasible nor desirable – and a higher RMB would not reduce China’s trade surplus. Instead,
monetary control and normal private-sector finance for the trade surplus require a return to a credibly fixed nominal
yuan/dollar rate similar to that which existed between 1995 and 2004. But for any newly reset yuan/dollar rate to be credible as a monetary anchor, foreign “China bashing” to get the RMB up must end.
Currency stabilization would allow the PBOC to regain monetary control and quash inflation. Only then can the
Chinese government take decisive steps to reduce the trade (saving) surplus by tax cuts, increased social expenditures, and higher dividend payouts. But as long as the economy remains overheated, the government hesitates to take these trade-surplus-reduction measures because of their near-term inflationary consequences.
Keywords: China Finance; RMB Exchange Rate; Global Imbalances
Key words: China finance; RMB exchange rate; global imbalances

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