Letters to The Editor: New System Ties Hands of The Chinese Even More (Financial Times)
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07/27/2005 Sir, I fully support your concerns "Making sense of China's choice" and those of Morris Goldstein and Nicholas Lardy ("China's revaluation shows size really matters", both July 22 - subscription required) on China's choice of exchange rate regime. The revaluation has been too small and the daily trading band of 0.3 per cent is too narrow. But I want to add two related concerns regarding the newly announced regime. First, it lacks credibility. Second, in contrast to what many analysts claim, it does not give the People's Bank of China more flexibility in the conduct of monetary policy. The key ingredient for a credible exchange rate system is that it needs to be consistent with fundamentals. To the extent that markets reflect fundamentals, even to a limited degree, lack of consistency was already apparent in the first trading day of the renminbi under the new system. The one-year renminbi non-deliverable forward rose on July 22 to 7.64 to the dollar reflecting increased market perceptions of a heavily undervalued currency. While fundamentals would have called for a further appreciation, the Chinese currency slightly depreciated from 8.1100 to 8.1111, signalling the Beijing authorities' intentions to control the currency in large measure rather than letting markets play a role. While it is understandable that the authorities want to avoid speculators to benefit from a "one-side bet" (i.e., having the certainty that the renminbi will only appreciate), the chosen system cannot do the trick. By leaving the currency misalignment uncorrected, the authorities have placed themselves in a position of "trying to beat the markets", a very costly and risky game that might even contradict policy objectives. One such policy objective is the achievement of greater monetary policy flexibility. In my view, however, the new system ties the hands of the Chinese monetary authorities even more. Allowing very limited room for exchange rate movements will just fuel speculators' appetite. This is because of the inconsistency between policies to discourage further capital inflows and the intended objective of controlling the sharp expansion of domestic credit. The authorities can increase capital controls and/or loosen monetary policy to keep interest rates low and discourage inflows. But an expansionary monetary policy fuels rather than contains the growth of domestic credit. Thus, by putting itself in a position of "having to fight" speculation, the People's Bank of China might be forced to give up the more important objectives of ensuring price stability, sustainable growth and a strong banking system. The Chinese authorities might win this self-imposed war, but is the cost worthwhile? In my view, the best way for China to win a game against speculators is to let the exchange rate move freely, while keeping existing capital controls in place, at least in the immediate future. |