Beijing’s Tactical Retreat

This article appeared in Forbes on August 24, 2005.

Under a barrage of fallacious arguments fromthe Bush Administration and the U.S. Congress, Beijingmade a tactical retreat on July 21. It "reformed"China's exchange-rate regime.After a decade in whichthe yuan had been linked to the U.S. dollar at a fixedrate, China adopted a managed floating-exchange-rate regime.And on the new system's initial day of operation the yuan wasallowed to move from 8.28 to the dollar to 8.11, a 2.1% yuanappreciation.

U.S. Treasury Secretary John Snow hailed these changes as apositive first step. For months he had been piously lecturing theChinese about why it was in China's interest to dump its fixedratesystem and engineer a yuan appreciation.According to SecretarySnow, these changes would "allow China to more easilyand effectively pursue price stability, stabilize growth and respondto economic shocks."

That latest version of Uncle-Sam-knows-best is laughable. Itis not as if China has been making a mess of its economy. Sincethe yuan's fix to the dollar in 1995, China's real growth rate hasbeen second to none, exceeding 8% per year on average. It alsopassed the Asian financial crisis shock test with flying colors.Real growth was 6% in 1998, the year after the Thai baht collapsedand set off a wave of Asian recessions, and 6.2% in 1999.And all this growth has been accompanied by tame inflation—an average annual rate of 2.25%, less than the U.S. rate.

But it's not the first time U.S. special interests have prevailedin the name of helping China. During his first term Franklin D.Roosevelt delivered on a promise to do something for silver.Using the authority granted by the Thomas Amendment of1933 and the Silver Purchase Act of 1934, the Roosevelt Administrationbought silver. This and bullish rumors about U.S. silverpolicies helped to push the price of silver up by 128% (calculatedas an annual average) in the 1932-35 period.

Bizarre arguments contributed mightily to the agitation forhigh silver prices. One centered on China and the fact that it wason the silver standard. Silver interests asserted that higher silverprices—which wouldbring with them anappreciation in the yuan—would benefit the Chinese by increasing their purchasingpower.As a special committee of the U.S. Senate reported in1932, "Silver is the measure of their wealth and purchasingpower; it serves as a reserve, their bank account. This is wealththat enables such peoples to purchase our exports."

Things didn't work according to Washington's scenario. Asthe dollar price of silver and of the yuan shot up, China wasthrown into the jaws of depression and deflation. In the 1932-34period gross domestic product fell by 26% and wholesale pricesin the capital city, Nanjing, fell by 20%. In an attempt to securerelief from the economic hardships imposed by U.S. silver policies,China sought modifications in the U.S. Treasury's silverpurchaseprogram. But its pleas fell on deaf ears. After manyevasive replies the Roosevelt Administration finally indicated onOct. 12, 1934 that it was merely carrying out a policy mandatedby Congress. Realizing that all hope was lost, China was forcedto effectively abandon the silverstandard on Oct. 14, 1934,though an official statementwas postponed until Nov. 3,1935. This spelled the beginningof the end for Chiang Kaishek'sNationalist government.

History doesn't have to repeatitself and probably won't.After all, a significant yuan appreciationagainst the dollartoday would result in a nastydeflationary impulse, as it didin the 1930s. For example, anappreciation in the yuan of20%—a number tossed aroundby many Washington politicos—would generate a 16% deflationaryimpulse. This would completely sink China's bankingsystem and spread untold hardship among China's 800 millionrestless rural residents.

Beijing knows this. Perhaps this explains why the People'sBank of China chose to adopt the type of "flexible" monetarysetup employed in Singapore. Since 1981 the Singapore dollar'sexchange rate has been managed against an undisclosed basket ofcurrencies.Under Singapore's unique version of a managed floatingexchange rate the Singapore dollar has shadowed the U.S.dollar. Indeed, today's exchange rate of 1.67 to the U.S. dollar isalmost exactly the same as the average value in 1991 and 1999.

China's choice of Singapore's basket approach to managedfloating could portend a wise combination of emollientrhetoric with a realistic defense of China's economic interests.For yuan bulls it could mean some pretty big disappointments.The ones who are taking out dollar loans to buy and hold yuanare incurring significant carrying costs while waiting in vain fora payday.