In a competitive exchange‐rate system, millions of traders — not a central authority — will take account of all relevant information and there will be constant, small adjustments in free‐market rates. Futures markets will exist to smooth rates over time and hedge bets. One‐way speculation will not occur, as it does under pegged but adjustable rates.
The surprise drop in the yuan‐dollar exchange rate by 1.9 percent on the first day of the new scheme for setting the central parity is reminiscent of price “reform” in the Soviet Union under central planning. Prices would be frozen for long periods, without regard to world prices, and then suddenly increased. Without the guiding hand of markets, and without free trade, there was no way to know the right prices — that is, those that would clear the market.
China has allowed more flexibility in the yuan’s movement around the official parity since July 2005, but within strict limits and subject to political control. The yuan was supposed to be managed with respect to a basket of currencies of China’s key trading partners, but in practice it has been managed primarily with regard to the dollar. China’s export growth has slowed as the dollar, and hence the yuan, appreciated against the euro and Asian rivals.
China’s exports to the European Union declined by 12 percent in July from a year ago, and overall exports declined by 8.3 percent. Officials report China’s growth in real GDP at 7 percent, the slowest in many years; but actual growth is most likely closer to 5 percent.
Following on the heels of China’s stock market stabilization, in which bans were placed on trading and the government pumped in funds to shore up share prices, with only minimal success, the devaluation of the yuan endangers the central government’s promise to rebalance the economy away from export‐led growth to greater domestic consumption.
When the People’s Bank of China sells yuan for dollars to lower the yuan‐dollar exchange rate and boost exports, it risks inflating the money supply. Past episodes of rapid money growth have led to serious inflation and instability. Also, capital outflows — due to uncertainty caused by the turmoil in the stock markets, greater state intervention and the risk of reform reversal — are putting downward pressure on the exchange rate.
To strengthen its currency, China needs widespread liberalization. Capital will then stay in, and flow into, China. China watchers in Congress should not just look at one price — the exchange rate — to see what China is doing. They need to look at the balance between state and market, and thus the progress of institutional change in China.
The challenge is to allow markets more scope and the state less power.