Tuesday 11 November 2008
US Economist McKinnon: Fix RMB Rate Against USD Again
Ten years ago China successfully rode out the East Asian financial meltdown with a fixed exchange rate and a surge in government disbursement. Can China use the same method to survive the current financial crisis? A big government stimulus package was announced this weekend, but what about the RMB?
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US Economist McKinnon: Fix RMB Rate Against USD Again
10 November 2008
Ten years ago China successfully rode out the East Asian financial meltdown with a fixed exchange rate and a surge in government disbursement. Can China use the same method to survive the current financial crisis? A big government stimulus package was announced this weekend, but what about the RMB?
Ronald I. McKinnon, a professor of international economics at Stanford University, states, “During the ‘97-’98 Asian financial crisis, China conducted internal expansion of its economy instead of RMB depreciation. I think China just needs to do the same now.” He was speaking at the second Asia-Pacific Economic and Financial Forum held by the Central University of Finance and Economics.
Prof. McKinnon believes now is a good time for China to implement fiscal expansion. Meanwhile he believes China should once more maintain a fixed exchange rate, as a financial expansion needs the support of a stable RMB.
Fixed Yuan Rate Again?
China began its financial reform in 1994. The government allowed current account convertibility and maintained the RMB exchange rate at around 8.27. McKinnon believes this built a solid basis for China’s economic growth.
“But ironically, now the US banking system has problems and the financial situation is very bad. The situation in 1990s has been completely reversed. China is so strong and the US is so weak,” said McKinnon.
McKinnon points out that China has the largest trade surplus in the world, and is the holder of much overseas debt, all in dollars. China has some direct investment overseas, but more overseas capital has flooded into China, and accumulated in the form of a trade surplus. “Foreigners are unhappy to see China’s rapid accumulation, thinking China is manipulating its own exchange rate, and they demand quick RMB appreciation. The same story happened to Japan 25 years ago,” said McKinnon.
“A fixed exchange rate is good for China. Despite pressure from some other countries, China can fix its exchange rate to avoid the liquidity trap that harmed Japan, and cut Japan’s interest rate to zero,” said McKinnon. After China’s exchange rate reform in July 2005, many have believed RMB would appreciate into the future. But If RMB appreciates by 6% every year, the value of overseas investment by Chinese banks and insurance companies will be cut by 6% every year. And due to appreciation expectations, hot money has flooded in, making it more difficult for the People’s Bank of China to regulate the economy with monetary policy.
From the reform in July, 2005, RMB appreciated against USD until July 2008. But in July the USD moved up against the Euro, Australian Dollar, and Canadian Dollar. RMB appreciation was swiftly stopped against USD. “My prescription is to maintain the current exchange rate, at 1:6.8, and don’t let it change,” said McKinnon.
Errors In Exchange Rate Theory
McKinnon said some current economists’ exchange rate theories are not completely correct: first, that exchange rate will affect the trade surplus; second, that appreciation can relieve inflation; and third, that a flexible exchange rate can solve currency mismatch.
McKinnon believes that behind the trade surplus lies the deposit ratio. China’s huge trade surplus is led by its high deposit ratio, and the huge trade deficit of the US is caused by its vastly lower deposit ratio. An excessive deposit ratio has led to China’s current account surplus, and change only in the exchange rate won’t change the investment and deposit situation. As an example, although the yen has appreciated, Japan’s trade surplus is still rising.
As for the relation between exchange rate adjustment and inflation, McKinnon said if a currency appreciates continuously, prices will fall, as happened in Japan. But if the exchange rate balance is lost, and if the currency appreciates by 6% yearly, it will lead to hot money inflow and the central bank will lose control of currency supply. What happens next will be the opposite of “appreciation helping to relieve inflation”.
McKinnon thinks the government needs to take powerful fiscal measures if it wants to promote adjustment to China’s investment and deposit ratios and remedy the imbalance between deposit and investment surplus. As the economy is in a downturn, fiscal stimulus helps to cut the trade surplus and relieve pressure from the US at the same time. Fiscal expansion should be effective and should be able to stimulate economic growth. But in such circumstances, the exchange rate needs to be stable.
“Now the US financial system has a big problem, and China has become a powerful factor in globalization. We need to function through stimulative fiscal policy. The US must agree not to criticize China again, and not to impose anti-dumping sanctions on China. The two countries can find a way to cope with the financial crisis together,” said McKinnon.
After three years of appreciation, expectation for RMB depreciation has wiggled the market. Due to the current USD appreciation, hot money may flow out of China and back to the US, and this may put depreciation pressure on China. Change in China’s basic economic situation, lower exports, and lack of investment and consumption, will all affect the expectation for RMB exchange rate.
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