Commentary

Free China, Float the Yuan

This article originally appeared in The Wall Street Journal Europe on September 3, 2003.
The growing chorus demanding a revaluation of China’s undervalued yuan to spur exports to China and narrow its trade surplus is misguided. Even if the yuan is allowed to appreciate against the dollar by widening its band, China will still have a comparative advantage in textiles and some other manufactured goods. Rather than discussing the size of the yuan’s trading band with the dollar, or how far to move the upper limit of that band, attention should focus on normalizing China’s capital markets and abandoning the peg altogether.

The right to freely hold and invest foreign exchange is an important component of economic and personal freedom. If the Chinese Communist Party were to end capital controls and make the yuan fully convertible, the ossified system of state investment planning would end and China could move steadily toward a modern, market-based financial architecture.

Ending capital controls would force Beijing to choose between monetary independence and a hard peg. If policy makers opted to let market forces determine the foreign exchange value of the yuan, monetary policy could be used to anchor the long-run purchasing power of the yuan. Capital freedom would complement and strengthen trade liberalization, and market discipline would thwart those policies that undermined property rights and freedom.

As long as China controls the ownership of capital, including foreign exchange, people in China will be subject to exploitation by the state. As Sir Alan Walters, former economic adviser to Margaret Thatcher, noted with regard to transition economies, “Restricted capital convertibility ensures that it is still possible for the government to draw a ring fence around its subjects and expropriate them at will.”

Internationalizing China’s capital markets would normalize them and end one of the CCP’s last vestiges of centralized planning. President Hu Jintao could learn a lesson from the experience of post-World War II Europe, which was subject to capital controls and used those controls to perpetuate national economic planning. Economist Barry Eichengreen, writing in the latest issue of Foreign Affairs, notes, “Controls on international capital flows, retention of which was permitted under the Bretton Woods settlement, gave each government the leeway to elaborate a national economic plan. But capital controls did nothing to rebuild Europe’s trade or to create confidence that Germany’s economic might would be funneled in productive directions.”

China’s current institutional arrangement — a pegged exchange-rate regime, a closed capital account, and a central bank that tries to use monetary policy to manage both the exchange rate and the price level — is untenable in the long run. Persistent current-account surpluses and growing capital inflows have increased foreign exchange reserves at the People’s Bank of China to nearly $350 billion. If capital inflows are allowed to expand the monetary base and state-directed investment continues at a rapid pace, excess growth of money (M2 is currently growing at close to 21% year on year) and credit could lead to mounting inflation.

The result would be a rising real exchange rate, even as the nominal rate remained pegged. That would in turn depress the growth of China’s exports and increase imports. But that method of adjusting the trade balance would be costly and slow compared to allowing the yuan to float, promoting capital freedom, and concentrating domestic monetary policy on price stability.

When the Communist Party forces individuals to sell most of their foreign exchange to the PBOC in order to maintain the nominal peg of about 8.28 yuan per dollar, those individuals lose the opportunity to invest in foreign capital markets. That “backdoor nationalization,” as John Greenwood, chief economist at Invesco Asia, Ltd., has called it, is inconsistent with economic freedom and misallocates capital.

Strengthening property rights in China by normalizing capital markets would let capital flow to its most-valued uses as determined by private investors, not party officials. Stronger property rights for all investors, domestic and foreign, would attract new capital. With a flexible exchange rate and sound government policy, the yuan would appreciate and help normalize the balance of payments.

According to Greenwood, “If China’s capital markets and its industries were normalized (through deregulation, proper implementation of the rule of law, the encouragement of private markets, and extensive private ownership), then China’s balance of payments would no doubt undergo a major transformation.”

It is in China’s interest not to delay moving to a freely floating exchange rate and opening its capital account. Although those reforms are not sufficient to avoid a banking crisis, they can put added pressure on Beijing to restructure state-owned banks and allow greater competition. Moreover, experience has shown that a misaligned currency and capital controls are costly and unsustainable ways to promote development. Delaying real reform is apt to deepen, not prevent, a future financial breakdown.

Without capital freedom and flexible exchange rates, China will continue to build political ill will. By focusing on capital freedom and the need to normalize capital markets, the rest of the world would be doing the Chinese people a favor. By instead focusing narrowly on where the yuan is pegged to the dollar, the U.S. and Europe are allowing these broader issues to go unaddressed.

Mr. Dorn is a China specialist at the Cato Institute in Washington, D.C. and coeditor of China’s Future: Constructive Partner or Emerging Threat?