The case for gradualism: why a quick fix for China's currency would be a mistake.

AuthorWermuth, Dieter

In the Early seventies, the fixed-rate Bretton Woods system broke down because stability-minded countries in Europe and Asia were no longer willing to import inflation from the United States. As long as the dollar was a scarce commodity, backed by gold, it was an advantage to use it as an anchor, but when the Vietnam War was increasingly financed via the printing press, when America's external deficits began to explode and inflation to rise and spill over into other countries, the consensus that served the post-war economies so well finally broke down. The major currencies have been more or less freely floating ever since.

Bretton Woods has been making a comeback in Asia. The Chinese renminbi has been firmly pegged to the dollar at a rate of 8.28 for eleven years by now. Again, the world is being flooded with dollars, and without large-scale purchases by Asian monetary authorities the external value of the greenback would have declined substantially. A massive accumulation of international reserves has been the result of those interventions. This in turn has created vast amounts of domestic liquidity in Asian countries where printing presses must be running day and night. The difference between thirty-five years ago and now is that, so far at least, there is almost no indication that inflation is getting out of hand. So the countries which keep buying all those dollars do not complain, nor do they want to give up the peg as yet. In April, Chinese consumer prices were just 1.8 percent higher than one year ago, an inflation rate which the European Central Bank, for instance, would regard as price stability. As far as growth is concerned, the fixed exchange has had no visible disadvantages: the International Monetary Fund estimates the average annual real GDP growth rate for the twenty years through 2006 at 9.1 percent, with almost no evidence that the momentum is about to fade.

It is therefore not the Chinese who want to untie the dollar bond, it is rather the Americans who are pushing for a realignment--more precisely, for an appreciation of the renminbi. The Chinese would prefer to argue that something that ain't broke needs no fixing. They are dragging their feet and will only allow some upward adjustment of their exchange rate if the likely political repercussions of sitting tight outweigh the benefits. There is no theoretical limit to the amount of dollars they are able to buy. If the renminbi were weak, the situation would be quite...

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