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Thursday, July 28, 2005

China’s Currency and Fixed Exchange Rates

Floating exchange rates are not good for free markets

by StFerdIII

China’s ‘unpegging’ of the Yuan to the US$ is thankfully a minor change and adheres to the principle of currency predictability. We should not see any major dislocation from unpegging the Yuan and allowing it to float within a 2 % band. This is a major positive for the global economy. Free markets need stability and not the kind given by state ownership, government control, and nationalist chest beating, as evidenced in the EU-nuch lands or in Russia. Rather stability in a healthy trade environment means investors can count on the permanence and transparency in honest institutions; an enforceable legal code; democratic governance; market competition; financial market depth; and predictable currency values. China has none of the above, save a stable currency regime. During the past 10 years a strongly pegged Yuan gave investors a sense of security and allowed $60 billion per annum of foreign direct investment, which is the linchpin of Chinese economic growth, to flood into the coastal regions of the country. Without the currency peg, and a predictable currency value we would never have seen such rapid Chinese economic growth.

Historically with the exception of the Swiss franc which is anchored around an important banking sector, floating currencies have usually ended up being devaluating currencies, which has negatively impacted business and financial investments. The pre-Euro EU experienced wide and deleterious variations of at least 40 % over 40 years around the Deutsche Mark, resulting in manipulated currency regimes, nationalized industries and labor-product market rigidities. Scrapping the DM the EU launched the Euro in 1999 at US$1.17 and it has since fluctuated between 80 cents and $1.40, and now rests at $1.21 or so today. These wild variations have had an enormous impact on EU business and investment. The British pound and Yen have also faced the same rollercoaster ride in the past 15 years. Smaller currencies are not immune either. The C$ fell 40 % from 1970-2000 and has reflated 30 % in the past 3 years, impacting the importation of equipment, technology and productivity enhancing assets while sharply affecting various export sectors.
Australia and New Zealand have imitated the Canadian example. The Russian ruble has fallen by 500 % over the past 6 years wiping out earnings as wages did not keep pace with such inflation, and artificially increased taxation as revenues and profits magically rose.

Floating currencies cause fluctuations that impact investor decisions, business profitability and consumer purchasing power and are in the main a negative influence on international trade.

It appears that
China’s managed floating regime is a smart move that avoids the problems of floating currency regimes. In press announcements the Chinese maintained that the U.S. and G7 had advised: “Moving into a managed floating exchange rate regime based on market supply and demand. … RMB [Yuan] will no longer be pegged to the U.S. dollar and the RMB exchange rate regime will be improved with greater flexibility.” Such concepts should help relieve US protectionist pressure and avoid trade restrictions and friction. It also prevents speculative monies from destabilizing the Yuan in a pure floating exchange rate regime. Importantly such a managed float does not affect the fundamental value of the US dollar, commodity prices expressed in dollar terms, or bond yields. This minimalist floating regime makes political, economic and trade sense.

China there are benefits as well. Managing the Yuan to a dollar-dominated basket of currencies means currency stability and more non-inflationary growth. It also negates an appreciation of the Yuan, which could cause deflation in China and inflation in the U.S. The currency-basket rule also eliminates the threat of a total loss of confidence by international investors if something should go wrong with the key Yuan-US conversion and value rate.

In the main currency fluctuations are detriments to growth - witness
Canada with economic growth at ½ US levels, Japan mired in a 10 year recession, or Europe which has a stagnant economy. Free markets function when monetary units are predictable. China has been successful because of currency stability. China’s banking, market competition laws, governance structures and legal codes are non-transparent, corrupt or unstable, yet the currency relationship with the US has allowed investors to take risks, plan investments and realize returns.

Politicians instead of trying to buy protectionist and union votes should leave China alone and applaud its economic growth which is hinged upon a stable rate exchange with the US$. We need to let the Chinese economy grow and aid world economic growth through stable exchange rates. Hopefully the many other shortcomings of Chinese society and its economic-political structure will be dealt with as the country becomes richer and more integrated with the world economy. Indeed
Canada, the EU, Japan and other nations should take a hard look at the Chinese example and learn something. Maybe they should consider a managed currency rate regime. ©