Mundell and China
Jude Wanniski
May 9, 2005

You may not know or have forgotten that Bob Mundell, the prime-mover of supply-side economics back in the 1960s, has been spending a lot of time in China in recent years, has a school of higher learning named after him in Beijing, and has greatly influenced the government on its conduct of monetary policy. As much as the Bush administration wants China to cut the yuan`s 10-year link to the dollar, Mundell has counseled keeping it fixed at 8.28 to the dollar. His influence is also palpable in today`s Wall Street Journal op-ed, China Syndrome," by Steve Hanke and Mike Connally, both friends of Mundell's. Here`s the key paragraph:

According to Nobelist Robert Mundell, who is honorary president (along with Xu Jialu, vice chairman of the Standing Committee of the People`s Congress) of Beijing`s Mundell International University of Entrepreneurship, a substantial yuan revaluation would cut foreign direct investment, cut China`s growth rate, delay convertibility, increase bad loans, increase unemployment, cause deflation distress in rural areas, destabilize Southeast Asia, reward speculators, set in motion more revaluation pressures, weaken the external role of the yuan and undermine China`s compliance with World Trade Organization rules.

As you might imagine, Mundell has close contacts with China`s monetary authorities, and he tells me he has conveyed these warnings to them repeatedly. Where Fed Chairman Alan Greenspan and Treasury Secretary John Snow have recently argued that it would be in China`s best interest to float the yuan, Mundell (still a Canadian citizen by the way) argues the opposite and told me this morning that he does not believe China will revalue. The premise of the WSJ op-ed, though, warns of a "significant" revaluation in the neighborhood of 25%, while even those speculating that China might bow to pressures from Washington do not believe it would float the yuan or would repeg at more than 10%. If it did "float" the yuan, Mundell actually believes it would sink against the dollar, not appreciate. When the People`s Bank of China allowed the yuan to float for 20 minutes last week, perhaps because of a glitch, it appreciated by the tiniest of fractions.

Mundell`s greatest hope for China is an early end to the currency`s inconvertibility. There are of course risks in removing the capital controls that prevent Chinese from converting their yuan holdings into foreign assets. Beijing`s fear is that wealthy Chinese and millionaires are now proliferating like weeds will immediately cash in yuan for dollars (or yen or euros) in order to diversify their portfolios. Younger officials in the government are willing to take those risks, says Mundell, but they are still outvoted by their elders who wish to keep control of the wealth being generated internally. There really should be no risk at all in lifting the controls, although there might be a temporary period where those millionaires fear reimposition of controls and would rush to get as many yuan converted as possible. If Beijing allowed for that and kept its cool, there would be a reversal of capital flows back into China, along with a fresh flood of capital from the U.S. and elsewhere, picking up the bargains left by Chinese moving in the other direction. The net would be of great benefit to all sides, of course, and China would see its outside holding of dollar reserves run down to more reasonable levels. Beijing will be watching closely, I would imagine, now that Malaysia has lifted capital controls it imposed in 1997-98 amidst the turmoil of the Asian crisis.

The effect would be dramatic in China`s case, with convertibility bringing an end to the "A" and "B" shares reserved for citizens or foreigners. Mundell also believes there would be much greater ability for private rating services to assure the reliability of numbers being supplied by corporate entities whose shares are traded. This, he thinks, has been one of the biggest drags on China`s development, the risks associated with its incomplete market capitalism.

The points made by Hanke and Connally in their op-ed are excellent and should be reviewed by the Bush Treasury. The assumption behind the Schumer-Lindsay bill that would impose a 27.5% tariff on Chinese goods if it failed to revalue is that China would buy more U.S. goods and the U.S. would buy fewer from China following a revaluation of the yuan. The U.S. would simply shift its demand for Chinese goods to other Asian countries ready to fill our shopping basket with textiles almost as cheap as China`s. We would have to put up a tariff wall against the world to satisfy Senator Schumer`s garment workers and Sen. Lindsay`s textile workers. This would be okay, I believe, as long as the tariff was designed to produce revenue, as anything above a 15% ad valorem rate would see a falloff in revenue. The revenues, of course, would have to be put to productive use, though, or that solution would not be so hot.

The milestone we observed being passed earlier this month when Beijing hosted the leader of Taiwan`s Nationalist Party, with great fanfare reserved for only the most important foreign dignitaries is a great positive for China`s future. The big reason the Independence Party has been winning elections in recent years is that it throws a scare into the voters in the weeks before the election and as soon as power is retained, they cool things off to permit the continued commercial interchange with the mainland. This latest rapprochement seems designed to assure the Taiwan electorate next time around that Beijing is no threat, but ready to fete a national reunion. Will we see this by the 2008 Olympics in Beijing or its hosting of an international World`s Fair in 2010? I`ll bet we at least see a convertible yuan sooner than either date.