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Conflict and Confusion: China’s Currency Policy

Author: Sebastian Mallaby, Paul A. Volcker Senior Fellow for International Economics and Director of the Maurice R. Greenberg Center for Geoeconomic Studies
December 16, 2011
Financial Times

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The partisans of China's rise are brandishing a new argument. Not only is China the world's most prolific exporter, wealthiest sovereign creditor and second-largest economy. It is also on track to be the leading provider of the world's reserve money – perhaps within a decade, in the estimation of Arvind Subramanian of the Peterson Institute for International Economics. But China's miracle economy is not quite as miraculous as all that. Indeed, the internationalisation of the renminbi is less a sign of China's rise than of its internal confusion.

The renminbi's ascent appears superficially impressive. Renminbi-settled trade transactions came to Rmb957bn ($146bn) in the first half of this year, from next to nothing a year earlier. Renminbi deposits in Hong Kong have grown to almost Rmb620bn ($97bn), up more than tenfold since 2008. The Chinese authorities have extended renminbi swap lines to foreign central banks; they want the renminbi to be included alongside other top currencies in the "special drawing right", the quasi-currency issued by the International Monetary Fund. Given the frailty of the US, it is easy to see why commentators forecast "renminbi rules" in the near future.

But why is the renminbi ascending? The answer starts with China's post-2008 revolt against a supposed "dollar trap". By the time of Lehman Brothers' bankruptcy, China had $1.5tn worth of US financial assets, including about 7 per cent of all the "agency" bonds issued by government-linked lenders; the failure of the two biggest, Fannie Mae and Freddie Mac, showed the possibility that China could take a serious loss on this portfolio. Likewise, the post-Lehman meltdown triggered a collapse in global demand for China's exports, causing growth to crater in early 2009. Again, China's leaders concluded they were uncomfortably dependent on the quality of economic management abroad, particularly in Washington.

So far, so reasonable. But having correctly diagnosed their vulnerability to external shocks, the Chinese authorities were diffident in taking the logical next steps: to cease accumulating US financial assets; to accept the consequent appreciation of the renminbi; and to diversify away from exports. Instead, China's leaders ordered up a vast stimulus that temporarily disguised their structural surplus. Then they set out to reform the dollar-based monetary order, which they blamed for their predicament.

Of course, blaming the dollar is a digression. The truth is that China's vulnerability is homemade: nothing about the greenback's pre-eminence forces China to run a savings and export surplus, the root cause of China's huge reserve accumulation. But if China's frustration with the "dollar trap" appears confused, its proposed remedy is yet more muddled. Promoting the internationalisation of the renminbi as a rival to the dollar may sound pleasingly patriotic to China's leaders. But it contradicts most other aspects of their economic model.

China's growth miracle features capital controls, artificially cheap loans to favoured companies and a managed exchange rate. Renminbi internationalisation undercuts all three policies. Capital controls prevent foreigners from acquiring renminbi; internationalisation encourages foreigners to hold them. It follows that internationalisation also makes artificially cheap loans harder to fund, since it opens up a channel for savers to move capital offshore, where they can escape regulatory caps on interest rates. And as internationalisation allows foreign speculators to accumulate renminbi, it creates upward pressure on the currency – pressure that an exchange rate-targeting central bank has to offset by selling renminbi and buying dollars. So China's attempt to internationalise the renminbi, which springs from frustration with the dollar trap, paradoxically increases its vast dollar holdings.

This is expensive as well as ironic. Assuming China will one day stop holding down the renminbi's value, it is sure to rise against the dollar. The more dollars the central bank buys, the greater the portfolio loss it will suffer in the future. Moreover, as the central bank acquires dollars, it pays out renminbi. The resulting monetary stimulus has to be sterilised, creating a further challenge for the authorities.

Of course, China has managed contradictory policies before. But even if China's leaders muddle through the mess of unintended consequences their policy has wreaked, one thing is surely clear. Far from demonstrating the inevitability of China's rise, renminbi internationalisation illuminates the country's fraught fight against a worn-out economic model.

The writer directs the Maurice R. Greenberg Center for Geoeconomic Studies at the Council on Foreign Relations. A longer version of this appears in January's Foreign Affairs.

This article appears in full on CFR.org by permission of its original publisher. It was originally available here (Subscription required).

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