Four weeks from now, the US President, Mr Barack Obama, will visit India. A few days after that, the Prime Minister, Dr Manmohan Singh, will attend the G-20 summit in Seoul. At both meetings, India and the US will very likely adopt the conventional views about China — that it saves too much and accumulates too many dollars and is, therefore, a pain in the neck.
In this article I want to flag the rather unconventional view put forth by Ronald McKinnon, professor of international economics at Stanford. He is amongst the very few modern economists worthy of admiration. The reason: the sheer clarity of his thought.
In a recent, short five-page paper (“The Case Against Exchange Rate Flexibility for China: The Plight of an Immature International Creditor” *), he says, in a typically clear statement of the Chinese exchange rate problem, that: “China is in the historically unusual position of being an immature creditor: its own currency, the renminbi, is hardly used at all in financing its huge trade (saving) surplus. Instead the world — particularly the Asian part of it — is still on a dollar standard. The dollar is the invoice currency of choice for most of Chinese exports and imports and for open-market — that is, non-government, controlled financial flows. So we have the anomaly that the world's largest creditor country cannot use its own currency to finance foreign investments.” In other words, China is stuck. It made the crucial mistake of equating a paper currency with gold. Mercantilism worked for gold; it cannot work for the dollar.
So, to echo Mark Twain, reports of the dollar's impending death are highly exaggerated. It is, and will continue to be, the global signature currency for perhaps another two decades.
Who knows, by then, the Communist party of China may have taken its place beside the Communist Party of the Soviet Union.
The dollar will stay the pre-eminent currency of the world — and therefore China's fate is in American hands — because such things change very slowly. It took all of 70 years — from 1870, when Germany first displaced France as Britain's main global rival, to 1945, when Britain went bust after World War Two — to dislodge the sterling as the global currency of confidence.
Even if one allows for the Tofflerian theory that the future comes to us faster now, the dollar would appear to be safe for several reasons, not the least of which is known in modern international relations as ‘comprehensive national power'. It includes all sorts of power: political, economic, military, technological and cultural. The US is bulging with all of these.
If these premises are granted, if only for the sake of argument, how does the world get around the problems that the yuan's exchange rate is causing? Mr McKinnon's answer is that there is no market solution to it, as so many American economists are suggesting.
“If it (China) tried to float the RMB, so that the People's Bank of China (PBC) was neither a buyer nor seller of foreign exchange, then non-state Chinese banks would not accept the risk of financing the huge trade (saving) surplus by accumulating dollar claims.
There would be no net buyers of the dollars thrown off by China's large export surplus. The RMB would spiral upward indefinitely against the dollar with no well-defined upper bound until the PBC was dragged back in to reset the rate.
Unlike what the US Treasury Secretary, Timothy Geithner, would suggest, there is no market solution for the exchange rate for a large immature creditor country.” If Mr McKinnon is right, as he seems to be, China will bow to US pressure but not by much at a time. This means the process of getting the yuan down to, say, four to the dollar is going to be a long one. This interval is necessary to allow Chinese companies to adjust to lower export profits by selling more domestically so that higher profits from those maintain their overall profitability.
At its core, the problem, according to Mr McKinnon, is of exchange risk. If there is even the slightest possibility that the dollar will depreciate, private Chinese companies refuse to accept the exchange risk. This means that the government has to assume this risk.
So it is now holding $2.5 trillion and is trying hard to ensure that some of this does not flow back into China and create problems for monetary management. Mr McKinnon lists four clever ways in which China is keeping the money out.
They seem to be working, to the extent that the investments made by it are illiquid and therefore money will not flow back into China.
Can you think of anything sillier? Is it really very cunning to first run up such huge surpluses and then end up financing foreigners? If so, how come only the Japanese and Singaporeans practise it? Why make your people work so hard and then hand over the profits to foreigners?
Short answer: these guys are actually pretty obtuse because this is really no different from what the imperial powers used to do, namely, extract a surplus from their dominions and take it all away.