If China continues on its blistering growth path, it faces the possibility of accelerating inflation and social unrest.
If it fails to reduce its large bilateral trade surplus with the U.S., it faces protectionist pressures with unintended consequences for global financial stability, especially if the People's Bank of China begins to diversify its portfolio. So what is China to do?
Regardless of outside pressure to revalue the yuan, it's in China's self-interest to do so. Letting the yuan further appreciate against the dollar, while also liberalizing capital controls, would free the PBOC to focus on domestic price stability and stem the massive buildup of foreign exchange reserves.
Moving toward a more flexible exchange rate, however, will take time and patience — both of which are in short supply in Washington.
Indeed, Sen. Charles Grassley, R-Iowa, a key sponsor of a bill designed to "force" China to revalue its currency, describes progress on currency reform as "glacial."
The International Monetary Fund, U.S. Treasury, Congress and Commerce Department are all putting pressure on China to appreciate its undervalued currency. And it looks certain that legislation will be passed this year that will make it easier to label China a "currency manipulator" in the sense of having a "fundamentally misaligned currency" — attested to by a persistent and large current account surplus.
U.S. firms will find it expedient to use China's undervalued currency as an excuse to bring anti-dumping actions or to apply for countervailing duties, even though Commerce treats China as a nonmarket economy. Using the threat of protectionism to motivate a change in China's exchange rate policy, however, is counterproductive.
Indeed, if China felt it was unfairly discriminated against, it could use its $1.3 trillion in foreign exchange reserves to counterattack. Merely by announcing that some of those reserves would be shifted out of U.S. government securities would have a huge negative impact on U.S. asset prices.
The decrease in wealth could far outweigh any increase in U.S. exports to China from a depreciation of the dollar against the yuan.
If China did as Sen. Charles Schumer, D-N.Y., and others wish and let the yuan appreciate by 27% or more, the overall U.S. current account deficit would not disappear, and U.S. consumers would be harmed by the higher prices of imports.
But if Congress focused on both capital and exchange rate freedom — with all Chinese citizens having the right to invest in U.S. assets — the yuan could actually fall against the dollar, with no upward pressure on U.S. interest rates.
Instead of concentrating on the yuan-dollar rate, Congress ought to tout the pillars of a free society: a transparent rule of law that protects people and property, monetary stability that prevents the government from defrauding the public as in Zimbabwe, and free trade.
Also, instead of telling countries how to run their exchange rate regimes, the IMF should preach the virtues of market-based regimes — a genuinely fixed regime (as with the pre-1914 gold standard) or a freely floating regime — as opposed to permitting intervention to achieve some equilibrium exchange rate that no one can possibly know in advance.
The IMF's latest surveillance decision, which was opposed by China, is intended to promote "external stability" and provide "clear guidance . . . on how (members) should run their exchange rate policies."
The IMF's failure to prevent the Asian currency crisis in 1997-98, which stemmed primarily from adherence to the flawed system of pegged exchange rates, raises serious questions about the fund's credibility in promoting external stability — especially in a world of pure fiat money.
China's growing current account surplus reflects an imbalance in domestic saving and investment, a closed capital account and an undervalued exchange rate.
The fact that Chinese households and firms save a substantial portion of their incomes is largely a reflection of the distorted interest rates and the financial repression in China, in which state-owned banks and enterprises dominate the capital markets.
Making the yuan fully convertible and allowing further outward investment would increase personal and economic freedom, but could jeopardize the fragile banking system. Keeping the current system risks creating inflation as the PBOC prints new yuan to support the dollar (though most of that liquidity is drained off by sterilization).
The IMF recognizes that external stability requires domestic stability and that institutions matter.
The institution that China needs most is a transparent rule of law that protects people and property against an intrusive state and that reduces corruption.
But does anyone seriously believe that the IMF or Congress can bring about that monumental change in China?