Currency conundrum: until the world economy improves, China has no easy way out.

• Author: McKinnon, Ronald

"The U.S. blasted China for its recent currency moves, calling the decline in the yuan 'unprecedented'.... The Treasury Department said that the weakening of the yuan would raise 'particularly serious concerns ' if it signals a retreat from Beijing's publically stated policy of scaling back intervention to let market forces play a bigger role. The report stopped short of labeling China a currency manipulator, a move that U.S. administrations have avoided for the past two decades."

--Wall Street Journal, April 16, 2014

Since late February 2014, the inverted scale in Figure 1 shows the recent depreciation of the yuan from 6.05 to 6.225 per dollar--a depreciation of a little less than 3 percent. Though insignificant in overall trade terms, especially when compared with the volatility of other floating exchange rate regimes, the yuan's unexpected weakening sparked the Treasury's furor.

The uproar was not surprising. After all, China has been under constant pressure from the American government to appreciate the yuan in the mistaken belief that a stronger currency would reduce China's large trade (saving) surplus--and reduce the large bilateral trade deficit of the United States with China (Figure 2). And China had seemed to be complying. The inserted table in Figure 1 shows the yuan appreciating more than 3 percent per year, albeit quite erratically, from July 2005 through 2013.

THE HOT MONEY PROBLEM

However, the international outcry obscured another, unintended but perhaps more troubling, feature of China's previous exchange rate policy: the tendency for sporadic yuan appreciation (even small movements) to trigger speculative inflows of "hot" money. With short-term interest rates in the United States near zero, and the "natural" interbank interest rate in faster-growing China at near 4 percent, an expected 3 percent annual appreciation, for example, translates into an "effective" interest-rate differential of 7 percent. This is an enticing spread for currency speculators who borrow in dollars and circumvent China's capital controls to buy yuan assets.

The hot-money problem is only made worse by the ongoing international political clamor for further yuan appreciation, usually from Western economists and politicians who blame the ostensibly undervalued yuan for China's current-account surplus with the United States and other developed economies. In reality, the trade imbalance reflects the difference between China's large savings surplus and the...