Thinking About China Jude Wanniski June 28, 2005

When Fed Chairman Alan Greenspan and Treasury Secretary John Snow last week testified before Congress on China`s economy, there was lots of attention given to the argument that China is gaining unfair trade advantages with the U.S. by pegging its currency to the dollar. It isn`t, of course. Yet while Snow agreed that China should float the yuan (renminbi) ASAP to permit trade flows to adjust, Greenspan poured cold water on the notion that such a move would not alter trade flows in a way that would save American jobs. 

Still, the Fed Chairman repeated the argument he made some weeks ago that it is in China`s self-interest to appreciate the yuan. The financial press did not seem to notice, but this time Greenspan clarified by saying such a move would reduce China`s inflation rate! This was a clear sign that Greenspan, who of course knows the currency peg means Beijing is importing its monetary policy from the U.S., believes the U.S. dollar is in an inflation zone. It also presents his judgment that China would benefit economically if its currency appreciated against the dollar and, ipso facto, against gold. Sen. Chuck Schumer [D NY] seemed happy enough to get Greenspan`s support for a stronger yuan, but if he had listened carefully, he would have wondered how China would benefit from a stronger yuan when Schumer has bought the idea that a stronger yuan helps the U.S.

Beijing is aware that it is importing a degree of inflation from the U.S., which it can see in the rising price of gold. But China`s government also understands that its currency peg has produced what Bob Mundell calls "an optimum currency zone." Indeed, they probably learned it directly from Mundell, who seems to spend half his time in China these days advising the government. At a Beijing conference June 1, where he addressed members of the Chinese cabinet, Mundell not only urged China not to retaliate against the restrictions the U.S. and Europe are imposing on its textile exports, but also said it should "do nothing" on the currency issue. According to the Chinese press:

Mundell said, "It would be "extremely damaging for China to change its fundamental policy" on its exchange rate. "China should keep its current policy forever -- as long as the (US) dollar remains stable." By saying "forever," he said he was talking about 5 to 10 years. 

Because of the improvement of productivity, it is easy for the real exchange rate of the Chinese currency to appreciate to the rest of the world, including the dollar, he said. But the best way to achieve the exchange rate appreciation is not through appreciation as urged by some Western countries, but through a change of wage rates. If the dollar becomes unstable, as it had in the past 200 years with four periods of instability, then China would have to put an end to its policy of pegging its currency to the US dollar, he said.

In mid-June, Mundell was in Hong Kong making an elabrate presentation on the same topic. The key insight is that China will not only damage its own economy by floating the yuan, but all of Asia. Even if the dollar is not pegged to gold, it has been stable enough to offset the costs of inflation with the great advantages of common currency. As long as the dollar and yuan are fixed, there are no costs of a currency hedging in trade between China and the U.S., and with several other Asian currencies keeping their currencies stable against the yuan, there is a de facto Bretton Woods zone. Mundell tells me that losing this zone would be so costly that Beijing should not consider a move unless gold went over $500 oz. 

When Mundell is talking about a peg of at least five to ten years, I would guess that`s because he does not see a new gold-based international monetary system in the cards before then. But if Beijing at some point decides that the costs of importing inflations and possibly new deflations outweigh the benefits of the currency zone, it might itself move toward a fixed yuan/gold price. By "toward" I mean with an intermediate step of the kind that has been discussed, pegging the yuan to a basket of currencies. If it would take such a step at the right time, it would dominate its own currency zone in Asia and increase the RMB`s attractiveness as money in relation to the dollar. 

The NYTimes front-page article today, "China Economy Rising at Pace To Rival U.S.," is a bit of a stretch, but it should be obvious that if Beijing keeps taking the advice of Mundell and Washington slumbers in gridlock, shaking its fist at China`s growing wealth, China`s compounding growth rate will surpass U.S. GDP in a matter of years, especially when so much of U.S. statistical production is composed of the chaos industry of lawyers, accountants, and financial advisors. Plus, there is our military-industrial complex that seems to have gone out of control, now promoting new spending on the grounds that China is beefing up its military. 

At the moment, though, there is a lot more barking than biting in Congress over the Yellow Peril in the PRC. As the Times piece points out, China has handled itself much differently than Japan did in the 1980`s, when it was the Yellow Peril in Washington. Because of its openness to investment and its acquisition of pieces of companies here, "China has many American corporate comrades, who have a stake in helping generate its growth." There`s no reason its Unocal bid should be killed by the government on national security grounds, and if it is, China will simply shrug and take its $18 billion on a shopping spree elsewhere.