China: Just Say No to Monetary Protectionism

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The Bush administration is prone to wrapping protectionistpolicy in free-market rhetoric. Treasury Secretary John Snowrecently urged China's leaders to adopt "a flexible, market-based,exchange rate" for its currency. China currently pegs its currency,the renminbi, at 8.28 to the U.S. dollar. A strong economic casecan be made for countries' adopting freely floating exchange rates.The administration's goal, however, is the political one ofincreasing the value of the renminbi in order to make China'sexports less competitive in the United States. In part,administration officials may be responding to congressionalinitiatives, such as the Senate bill cosponsored by Lindsay Graham(R-SC) and Charles Schumer (D-NY). That bill would impose a 27.5percent across-the-board tariff on Chinese goods if China does notfloat its currency within six months of the bill's passage.

The constraints set by the World Trade Organization's rules onplacing quotas or tariffs on Chinese imports-exemplified by theill-fated experience with steel tariffs-leaves the administrationthe option of trying monetary protectionism to appease U.S.manufacturers. Monetary protectionism occurs when governmentofficials try to obtain a trade or current account objectivethrough monetary manipulation of nominal exchange rates.

The Bush administration wants China to break its long-heldcurrency peg to the U.S. dollar, thereby causing the dollar to fallin nominal value relative to the renminbi and making U.S. goodsmore competitive with those of China. But such a policy will workonly if a real depreciation of the dollar occurs. If Chinesemanufacturers were to adjust their prices to reflect the newnominal exchange rate, any real depreciation of the dollar would beshort-lived. Nevertheless, monetary protectionism gives theappearance that politicians are doing something for theirmanufacturing constituents.

The problem is not China's peg to the dollar. Many othercountries peg to the dollar, or "dollarize" their economies, butthey are not singled out as unfair competitors. Some economistsfavor floating exchange rates, while others prefer fixed exchangerates. Most agree, however, that either a pure fixed exchange ratesystem or a pure floating rate system is superior to a system ofmoving pegs and "dirty floats." A dirty float occurs when a centralbank intervenes arbitrarily to alter the exchange rate in pursuitof monetary protectionism.[1]

China has been and should be criticized for its system ofcapital controls, which impedes the free flow of capital. It is thecapital controls that permit Chinese authorities to pursue monetaryprotectionism. The focus on fixed exchange rates is misplaced.

Hong Kong is a Special Administrative Region of China with itsown legal system, customs policy, and currency. The Hong Kongdollar is also tightly linked to the U.S. currency. The Hong KongMonetary Authority will not permit the Hong Kong dollar to fallbelow 7.8 to the greenback and, in practice, keeps the upper boundwithin 1 percent of that figure. No one in the Bush administrationhas hectored Hong Kong to float its currency.

In contrast to its mother country, Hong Kong has no capitalcontrols. As do goods, money moves freely into and out of the city.Getting rid of capital controls would compel China's monetaryauthority to deal with market pressures on its currency. Either anew peg or a free float would be adopted.

U.S. protectionists could no longer claim that China's policy ofundervaluing its currency provides its exporters with a competitiveadvantage. At the same time, China's central bank would no longerneed to purchase U.S. Treasury obligations in voluminous quantitiesto maintain its currency peg. Economist David Hale estimates thatthe monetary authorities of China and Hong Kong purchased nearly$100 billion of U.S. Treasury securities (including mortgage-backedsecurities) in the last 18 months. That policy props up the valueof the U.S. dollar.

Currently, China is in no position to eliminate capitalcontrols. Four large state-owned banks in China have $300 billionto $400 billion of nonperforming loans. Cleaning up those loanswould force state-owned enterprises (SOEs) to rationalize anddownsize. SOEs, the major borrowers, still employ more thantwo-thirds of the labor force. The unemployment resulting fromtheir sudden restructuring could lead to social upheaval and apolitical crisis.

China in crisis is not the Bush administration's goal, so itwill not press on the real economic issue. Calling for China tofloat its currency is political rhetoric to salve U.S. domesticpolitical wounds, not serious international economic policy. Underits WTO accession agreement, China committed to open its financialmarkets. Overall, China is living up to that agreement. Freermovement of capital will follow. Then China's leaders can decidewhether to adopt a new peg or float the currency.

The monetary experience in Hong Kong confirms that a monetaryauthority can maintain a peg if it forgoes monetary sovereignty.With a peg, changes in the domestic money supply are triggered bychange in international reserves. The monetary authority cannotguarantee domestic price stability with such a monetary system.Hong Kong has suffered price deflation for about five years.Because of the economy's flexibility, the dislocations caused bythat deflation have been less severe than they would have been inmany other countries.

It is doubtful, however, that Mainland China would choose such asystem for the long run. Perhaps after one or more revaluations,China will float its currency. The question will then be whether toadopt a free or a dirty float.

An open trading and investment relationship between China andthe United States would benefit the citizens of both countries.China's leaders need to move away from protectionism in all forms.President Bush should demonstrate leadership by not advocatingfurther protectionism, including the monetary variety.

[1] For afuller discussion of monetary protectionism, see W. Lee Hoskins andOwen F. Humpage, "Avoiding Monetary Protectionism: The Role ofPolicy Coordination," Cato Journal 10, no. 2 (Fall 1990):541-55.

Lee Hoskins

Gerald P. O'Driscoll Jr. is a senior fellow at the Cato Institute; he was formerly a vice president at the Dallas Fed and a vice president at Citigroup. Lee Hoskins is a senior fellow at the Pacific Research Institute and former president of the Federal Reserve Bank of Cleveland.