Monday, July 25, 2005

Parsing the Yuan Revaluation

Brad DeLong’s website excerpts an exchange between Nouriel Roubini of NYU’s Stern Business School and David Altig, who labors in the research department of the Federal Reserve, on the Wall Street Journal website concerning the Yuan revaluation.

An excellent exchange on Roubini's part, providing more clarity than usual.

But I found Altig's apparent confounding of "revaluation" and "forex market liberalization" completely off the mark—and somewhat dismaying, when one considers that the grey infallibility of the Fed apparently encompasses views on China that I find basically incorrect.

If China's move is anything, call it a "managed peg", with the only difference that instead of the transparency and stability of an unambiguous dollar peg, the PBOC can fiddle with the Euro, Yen, and dollar exchange rates based upon opaque policy and strategic considerations.

As I understand it, the foreign exchange markets in China exist to put buyer and seller enterprises together to smooth out current account transactions, not to set prices (the prices can only fluctuate within a derisory band), and certainly not to manage flows of speculative capital.

When the PBOC talks about "hot money"—which apparently excites Western economists with its implication that Chinese forex markets are open to the immense international capital flows that can overwhelm the price-setting ambitions of a single country--it is talking about improper forex inflows--a.k.a. illegal inflows--of speculative capital masquerading as operating or investment capital and parked in bank accounts or in real estate against an expected appreciation of the RMB.

This kind of “hot money” enters China secretly, with difficulty, and illegally, because of corruption and despite the vigilance of the PBOC. The free market invisible hand isn’t at work in the Chinese forex markets yet; it’s still government fiat disrupted by an occasional insinuating free market finger.

The Chinese have crystal clear memories of the Asian financial crisis suffered by countries with open forex regimes--which China escaped.

China's illiberal forex regime--which is more like a compulsory sale to the state of unallocated forex-denominated capital and excess forex operating funds at a fixed rate and very little like a purchase intervention to maintain some notional exchange rate, with comprehensive mechanisms meant to identify and hinder the inflow of speculative capital--has provided the Chinese government with immense foreign exchange reserves and the financial and political leverage that goes with them.

I don't think the Chinese government is complaining they have too much forex. The only downside, as Roubini points out, is sterilizing the domestic inflationary consequences of soaking up the copious RMB PBOC hands out in return for all those dollars.

If any forex-related crisis is going to bring down the Communist government, it's going to be domestic, money-supply driven inflation, not the unslaked thirst of the Chinese middle class for cheaper Kraft macaroni and cheese and whatever other seductive exports America can muster.

This makes genuine liberalization of China's foreign exchange regime unlikely.

The Chinese probably resent the fact that they were forced to revalue, thereby giving speculators increased incentive to finagle money into the country in anticipation of another revaluation.

But perhaps the most significant outcome for the Chinese is the fact that the cost of their domestic sterilization operations were cut by 2% and inflationary pressures were reduced correspondingly.

The significance for America is that China has abandoned its unipolar reliance on a dollar peg, and is now free to experiment with the implications of a multi-polar forex world in which China is insulated from genuine market pressures and can juggle the exchange rates to decrease the proportion of dollar inflows. Not exactly a big win for the American economy or free trade, IMO.

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