Solidifying a new G2: China and the United States should stabilize the yuan/dollar relationship.

• Author: McKinnon, Ronald I.

Tensions between the United States and China escalated recently when the new U.S. Secretary of the Treasury, Timothy Geithner, suggested in mid-January that China might be designated as a "currency manipulator." This prompted Premier Wen Jiabao on January 29 to mount a vigorous defense of China's existing exchange rate policy at a high-level meeting of world leaders at Davos, Switzerland. Mr. Wen pledged to keep the renminbi at a "reasonable and balanced level."

There is a good economic rationale for China's wanting to keep the yuan/dollar rate stable. First, as long as the fixed rate is credible--as it was between 1995 and 2004 at 8.28 yuan per dollar--it serves as an effective monetary anchor for China's internal price level. After inflation had exploded to more than 20 percent per year in 1993-1995, the fixed rate anchor helped China regain price-level stability. Second, the big fiscal stimulus, which Premier Wen is now contemplating, would be most effective if China's exchange rate were kept stable--as it has been since last July.

MONETARY CONTROL: LOST AND THEN REGAINED

However, China bashing, that is, mainly U.S. pressure to appreciate the renminbi, had become intense by 2004. To deflect American protectionist threats, the Chinese authorities began, as of July 21, 2005, to allow the renminbi to appreciate slowly--about 6 percent per year against the dollar. But the resulting one-way bet that the renminbi always rises prevented private capital outflows from financing China's huge trade surplus. Chinese banks and other financial institutions refused to acquire predictably depreciating dollar assets. Compounding the situation, inflows of international "hot" money to buy ever-higher renminbi assets led to enormous balance of payments surpluses.

To prevent the renminbi from ratcheting upward, the People's Bank of China intervened massively to sell renminbi and buy dollar assets. By July 2008, China had accumulated about $2 trillion in official exchange reserves. Despite massive sterilization efforts by the People's Bank of China, including imposing high reserve requirements on commercial banks, excess domestic money growth aggravated inflation from 2006 to July 2008. China's CPI inflation peaked at 8 percent in the spring of 2008.

Then, after the U.S. credit crunch of July 2008, the weak dollar became the strong dollar: the surprise 20 to 30 percent dollar appreciation against all major currencies, except the Japanese yen, that is still...