The Case for Stabilizing China's Exchange Rate: Setting the Stage for Fiscal Expansion

China & World Economy, Vol. 17, Issue 1, pp. 1-32, January-February 2009

32 Pages Posted: 4 Feb 2009

See all articles by Ronald McKinnon

Ronald McKinnon

Stanford University, School of Humanities & Sciences, Department of Economics (Deceased); CESifo (Center for Economic Studies and Ifo Institute for Economic Research) (Deceased)

Gunther Schnabl

University of Leipzig - Institute for Economic Policy

Abstract

China's financial conundrum arises from two sources. First, its large saving (trade) surplus results in a currency mismatch because it is an immature creditor that cannot lend in its own currency. Instead, foreign currency claims (largely US dollars) build up within domestic financial institutions. Second, economists, both American and Chinese, mistakenly attribute the surpluses to an undervalued RMB. To placate the USA, the result was a gradual and predictable appreciation of the RMB against the dollar of 6 percent or more per year from July 2005 to July 2008. Together with the fall in US interest rates since mid-2007, this oneway bet in the foreign exchanges markets not only attracted hot money inflows but inhibited private capital outflows from financing China's huge trade surplus. Therefore, the People's Bank of China had to intervene heavily to prevent the RMB from ratcheting upwards, and so became the country's sole international financial intermediary as official exchange reserves exploded. Because of the currency mismatch, floating the RMB is neither feasible nor desirable, and a higher RMB would not reduce China's trade surplus. Instead, monetary control and normal private-sector finance for the trade surplus require a return to a credibly fixed nominal RMB/USD rate similar to that which existed between 1995 and 2004. However, for any newly reset RMB/USD rate to be credible as a monetary anchor, foreign China bashing to get the RMB up must end. Then the stage would be set for fiscal expansion to both stimulate the economy and reduce its trade surplus.

Suggested Citation

McKinnon, Ronald and Schnabl, Gunther, The Case for Stabilizing China's Exchange Rate: Setting the Stage for Fiscal Expansion. China & World Economy, Vol. 17, Issue 1, pp. 1-32, January-February 2009, Available at SSRN: https://ssrn.com/abstract=1335595 or http://dx.doi.org/10.1111/j.1749-124X.2009.01128.x

Ronald McKinnon (Contact Author)

Stanford University, School of Humanities & Sciences, Department of Economics (Deceased)

CESifo (Center for Economic Studies and Ifo Institute for Economic Research) (Deceased)

Gunther Schnabl

University of Leipzig - Institute for Economic Policy ( email )

Institute for Economic Policy
Grimmaische Straße 12
Leipzig, 04109
Germany

HOME PAGE: http://www.wifa.uni-leipzig.de/iwp/

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