Letter to the Editor: Time for a currency board rule in China

This article originally appeared in The Financial Times on June 4, 2003.

From Prof. Steve H. Hanke.

Sir, Your editorial “Revaluing the renminbi” (June 2) counsels a revaluation of the renminbi’s pegged exchange rate of 8.28 against the US dollar to a new and stronger level. You then conclude that “this may be a second-best solution”. I agree. There is a better way to skin the cat.

Contrary to what you imply, the nominal renminbi-dollar rate is not the problem. China has both an exchange rate policy - the peg - and a domestic monetary policy. That is the problem. Since 2001, China’s foreign reserve war chest has swollen but these inflows have been sterilised. In consequence, the foreign reserve inflows have been neutralised and have not flowed through to the monetary base. This, in turn, has resulted in modest deflationary pressures that have put a lid on the renminbi’s real exchange rate appreciation (the nominal rate adjusted for inflation in tradable goods and services).

If China desires a truly fixed exchange rate - and it clearly does - it is high time to stop sterilising foreign exchange inflows and adopt an orthodox currency board rule. By doing so, changes in base money would be driven solely by changes in net foreign reserves. In consequence, China’s base money growth and inflation rate would be more rapid and the renminbi’s real exchange rate - the prices of China’s tradable goods and services versus the prices of their US counterparts - would increase.

By adopting an orthodox currency-board rule, China’s inflation would be allowed to adjust automatically and validate its fixed nominal exchange rate. It would also put an end to the whining about China’s “deflation” and its “super-competitive” exchange rate.

Steve H. Hanke is a senior fellow at Cato and a professor of applied economics at the Johns Hopkins University in Baltimore. He served as a senior economist on president Reagan’s council of economic advisors.