October 2003
Should China Float Its Currency?

For over a decade, China has pegged its currency to the U.S. dollar and employed an "interventionist" exchange regime that mimics the policies of other Asian states. The impact of China's exchange rate policies have been felt both at home and abroad, from the Chinese banking system to the U.S. bond market. These impacts and the growing deficits in U.S. current accounts with China have led to serious debate over China's exchange rate regime. Some of the specific questions that have arisen are whether China's currency is currently undervalued, whether China should change its exchange regime, and if so, how fast, whether China should floats its currency, and whether China should do more to open up its capital accounts. A group of experts gathered to discuss these and other issues with the hopes of shedding light on this continuing debate at an October 15 AEI event.

Randal Quarles
U.S. Department of Treasury

In light of the Treasury's strategy of promoting economic growth and enhancing stability throughout the globe, China is viewed though a comprehensive lens with an overall focus on growth, particularly in terms of China's integration into the global economy. Given that China is a key element of growth in both the industrialized and developing world, the Treasury seeks to promote China's domestic reforms and ensure that China follows through on its WTO commitments. Emphasis is placed on increasing the efficiency of China's financial sector and opening its markets to foreign goods.

The currency issue, while receiving considerable attention, is an element of--but by no means the fulcrum of--U.S. engagement with China. That being said, the currency issue is important given China's pegging the renminbi to the U.S. dollar at a fixed rate and its substantial accumulation of foreign reserves, which can threaten domestic price stability. Areas that are potential impact points internationally include China's trade with the United States and international community, both of which have increased significantly in recent years.  The price in goods, while experiencing some effects, is not as impacted by the Chinese currency situation.

A flexible exchange-rate regime is the most desirable in the long-run, particularly for an economy the size of China's, and this view has been communicated to the Chinese. China's restrictions on capital flows interfere with market forces allowing for a flexible regime. The Chinese have acknowledged this and have taken steps to liberalize capital movements. China has agreed to work on this issue with both the U.S. Treasury and the G7 group, again with the goal of integrating China into the global economy in a way that promotes overall growth.

Nicholas Lardy
Institute for International Economics

While a flexible exchange-rate in China is desirable in the long-run, the question is how fast can it be established? The Chinese financial system is "massively" insolvent and funded almost entirely from household deposits, including foreign currency that is very restricted. If Chinese capital controls were liberalized too quickly, there would be significant outflows as people put their money in foreign banks and currencies. Therefore, China should float its currency in the long-term but not in the short-term. In the short-term, China should look to revalue its currency in light of its current account surplus, high rate of imports, and a smaller capital account surplus, together which have led to the build-up in foreign reserves. The Chinese seem to acknowledge this whereby there is an expectation that they will revalue their currency in the near future.

The current situation is beginning to cause problems primarily in terms of the growth of lending in China. The Central Bank has tried to sterilize these effects, but the banks had been lending on the basis of past--not current--foreign reserves. In light of the recent growth in foreign reserves, then, the Chinese should find it in their interests to revalue their currency by an amount that would bring their balance of payments into equilibrium. The large credit build-up that has occurred since the middle of 2002 could lead to credit outstanding growing to one-third of GDP if the economy continues to grow at the rate of eight to ten percent. While this process produces some short-term benefits, looking at the long-term, it becomes more difficult to ease capital controls and move towards a flexible exchange rate.

Yusuke Horiguchi
Institute of International Finance

Looking at what the Chinese authorities should do about the currency issue and the problems it causes, China should adopt a more flexible exchange rate system for a "basket of currencies" rather than just the U.S. dollar and ultimately institute a managed floating exchange-rate system. China should be able to cope with the fiscal pressures that might come with instituting a "band" regime, much as they do now. China should follow an approach of successive approximation of whether those pressures exist until the right exchange rate is found.

Based on literature from the field, a country should not peg its currency if it faces fiscal dominance or if it has a weak banking system. Some of those who oppose floating the renminbi because of banking fragility favor pegging it at a higher level, which contradicts the accepted literature. Capital account liberalization and the health of the banking system is a separate issue from adopting a more flexible exchange-rate regime and the health of the banking system. Moving to a more flexible exchange-rate regime does not require capital account compatibility. Therefore, while China should not open its capital account given the fragile state of its banking system, it should still be able to float its currency.

China should not be afraid of its floating currency, the way many other Asian countries are. That being said, China should not float its currency immediately, but rather gradually phase-in greater flexibility. One of the first steps China needs to take is to dismantle the restrictions that impede the exchange markets. This includes allowing firms to deal with foreign exchange dealers and increasing the number of banks authorized to participate in foreign exchange.

John H. Makin
AEI

China will revalue its currency; there is a sense of urgency on this issue and the Chinese realize it. China is the classic case of an undervalued currency, with money flowing into the country and no way to sterilize it leading to a "bubble" syndrome that could soon burst. After Dubai, the perception is that the United States is concerned about the value of its currency, which leads to a sense of urgency if a large trading country such as China does not adjust its depreciating currency, because it creates a negative-sum game for everyone else. Money keeps coming into the country with no way to go out, so more is spent on assets inside the country to the point that there is no return on this spending, matched with the promises to pay lenders who have invested in those assets.

Floating the currency would be a way to start dealing with the insolvency of the banking system. It is hard to set a peg due to the uncertainty of where the peg should be, but a transitional float period is needed soon or the Chinese bubble will burst. Tension on the world trading system caused by China's attempts to get its labor prices up to world levels is also a concern. This could have a substantial influence on the China's trade policy, and lead to unfavorable results for the global community. In reality, no country wants a strong currency right now for various reasons. Therefore, China should float its currency at some point soon, and dismantle the capitals controls that are currently in place.

Harvey Z. Chen
Shanghai Jiao Tong University

Countries often fear moving to a flexible currency based on market forces, but ultimately they are glad to have made such a move. In China, similar fears may be justifiable as other sectors of the Chinese economy, such as real estate, are hurt by what is happening in the banking and finance arena. But other countries and groups believe that China is not sharing the burden of the global adjustments taking place. However, not everyone is affected the same way. U.S. multinationals and companies operating in China would not want to see the currency appreciate while those outside of China would. Attention should also be given to companies that have been left behind by the process of globalization and how this debate impacts them.

The Chinese leadership is very sensitive to outside pressure and demands. The leadership is trying to build a better international reputation so they are taking the demands to free the currency seriously, but publicly they do not want to be seen getting pushed around. The currency will eventually appreciate no matter what approach is taken, and the focus needs to be on the transition period, in particular in the banking industry. In addition, countries such as the United States should be prepared not to receive any benefits from reform in the short-term, but the U.S. should continue to encourage China to take its time in making changes to its exchange-rate regime.

Allan H. Meltzer
AEI

China should float, but do so gradually. Countries that liberalize too quickly, especially countries with weak banking systems, usually encounter significant problems. The Chinese most likely will not float their currency, but gradually appreciate it instead. There are things China can do too that would make the situation more win-win for everyone, including liberalizing their trade rules, allowing U.S. banks to buy Chinese assets, and modifying their ownership rules. The Chinese are going to follow their plan, but it may move along faster than they would like in order to avoid inflation, which the Chinese have a history of disliking.

China cannot avoid some revaluation in their real exchange rate; it is going to happen due to inflation or appreciation, or perhaps both ways. It is in U.S. interests to see that China moves with deliberate speed, but to large extent the United States has to see the problem the way China sees the problem. The Chinese see their principle problems as agriculture and unemployment, and the last thing they want to do is exacerbate those problems. Nevertheless, at this point, we know that the Bretton-Woods system works; it just takes time. Eventually we will see the same system working in China and throughout Asia.

AEI intern Jay Philip Nash prepared this summary.