China’s decision to abruptly devalue its currency against the dollar is being sold as a move toward a more market-determined exchange rate. But it is sure to infuriate those in Congress who have long argued that China is a currency manipulator. When Chinese President Xi Jinping visits Washington, he will face a more hostile Congress, even if the International Monetary Fund supports the new currency arrangement whereby market forces have a greater role in setting the daily central parity for the yuan-dollar exchange rate.

It is wishful thinking, however, to believe that China’s exchange rate regime will be left to the free market. The People’s Bank of China kowtows to China’s State Council, and the consensus is that maintaining “stability” trumps market liberalization. There is little doubt that stabilization measures (i.e., intervention) will limit movements in the exchange rate to what Beijing thinks will be desirable, not what market participants think.

The real issue in determining the pace of reform is the delicate balance between state and market in China’s “market socialist” system. True markets require institutions that protect and cultivate freedom. People have to be free to choose, which means they have to have effective rights to buy and sell, both domestically and internationally, and they have to have enforceable contracts, an independent judiciary, a transparent and just legal system and a free market in ideas. China is seriously lacking on all fronts.

The devaluation endangers the government’s promise to rebalance the economy away from export-led growth to greater domestic consumption.

In a competitive exchange-rate system, millions of traders — not a central authority — will take account of all relevant information and there will be constant, small adjustments in free-market rates. Futures markets will exist to smooth rates over time and hedge bets. One-way speculation will not occur, as it does under pegged but adjustable rates.

The surprise drop in the yuan-dollar exchange rate by 1.9 percent on the first day of the new scheme for setting the central parity is reminiscent of price “reform” in the Soviet Union under central planning. Prices would be frozen for long periods, without regard to world prices, and then suddenly increased. Without the guiding hand of markets, and without free trade, there was no way to know the right prices — that is, those that would clear the market.

China has allowed more flexibility in the yuan’s movement around the official parity since July 2005, but within strict limits and subject to political control. The yuan was supposed to be managed with respect to a basket of currencies of China’s key trading partners, but in practice it has been managed primarily with regard to the dollar. China’s export growth has slowed as the dollar, and hence the yuan, appreciated against the euro and Asian rivals.

In The Spotlight

China’s exports to the European Union declined by 12 percent in July from a year ago, and overall exports declined by 8.3 percent. Officials report China’s growth in real GDP at 7 percent, the slowest in many years; but actual growth is most likely closer to 5 percent.

Following on the heels of China’s stock market stabilization, in which bans were placed on trading and the government pumped in funds to shore up share prices, with only minimal success, the devaluation of the yuan endangers the central government’s promise to rebalance the economy away from export-led growth to greater domestic consumption.

When the People’s Bank of China sells yuan for dollars to lower the yuan-dollar exchange rate and boost exports, it risks inflating the money supply. Past episodes of rapid money growth have led to serious inflation and instability. Also, capital outflows — due to uncertainty caused by the turmoil in the stock markets, greater state intervention and the risk of reform reversal — are putting downward pressure on the exchange rate.

To strengthen its currency, China needs widespread liberalization. Capital will then stay in, and flow into China. China watchers in Congress should not just look at one price — the exchange rate — to see what China is doing. They need to look at the balance between state and market, and thus the progress of institutional change in China.

The challenge is to allow markets more scope and the state less power.

This article appeared in Newsweek.
Share

James A. Dorn
About The Author James A. Dorn [Full Bio]
James A. Dorn is Vice President for Monetary Studies and Senior Fellow at the Cato Institute. His articles have appeared in The Wall Street Journal, Financial Times and South China Morning Post. He has testified before the U.S.-China Security Review Commission and the Congressional-Executive Commission on China.




Talkback (3)

  • Guest (antonio moraca)

    Permalink

    I have read plenty of blogs before I could check out this one. To be honest, your blog is ranked in my Top 10 because of the simple yet very detailed information you have provided me. http://www.amazon.com/Decrum-Scarlet-Ultron-Leather-Jacket/dp/B013IB18ZI

  • Guest (Mornymorica)

    Permalink

    Well James A. Dorn! First I want to tell one thing about china. I have been given task to consider vital information about it. But sometime keep thinking that form which place I can take? Then getting after a long time searching. I should visit number of websties which are doing conversation about this conuntry. Best Essay Website For Students. So it is my opinion that info is really important and useful as well. Keep writing like this content.

  • Guest (faith)

    Permalink

    Currency exchange rate will vary from the status of a country and from the leader of the government. It's very important that you balance everything in your market to prevent inflation rate and devalue of currency and economic status of a country. Because every bad decisions results to bad reviews- http://www.topwritersreview.com/reviews/dissertationcapital/ of how you run your government.

Leave your comments

0

Quick Search

Stock Watch

1 DOW 21,348.49
-106.12 (-0.49%)    
2 NASDAQ 6,142.98
-91.44 (-1.47%)    
3 S&P 2,423.92
-16.77 (-0.69%)    

FREE Impact Analysis

Get an inside perspective and stay on top of the most important issues in today's Global Economic Arena. Subscribe to The Manzella Report's FREE Impact Analysis Newsletter today!