China: Caught in a Monetary Trap
posted on: March 26, 2008
Scattered throughout my writing are references to the way I view China’s currency regime, why I believe monetary policy is out of control, why I have insisted since 2003 that China’s trade surplus and foreign exchange reserves could only grow, and why I claim that the authorities are increasingly going to have to consider a maxi-revaluation as the only solution to a worsening problem.
I have been asked several times to summarize this argument. Here is a very brief summary:
Since at least 2002-2003, China has been caught in a monetary trap. By tying the value of the RMB to the dollar, and especially by setting it too low, the Chinese authorities ran the risk that in a time of excess global liquidity they would find themselves in the position of excess money inflows leading to excess domestic money expansion.
This would be reinforced as domestic money expansion funded rising industrial production, which would cause an increase in the trade surplus and so increase money flows further. Since global conditions at the time already suggested excess global liquidity, this risk was pretty high.
This is why I argued as far back as 2003-2004 that China’s then-high trade surplus could only rise, and as it rose it would necessarily feed domestic money expansion (the PBoC must create the local money with which to buy all those dollars), which would fund more investment, greater industrial production, and a rising trade surplus. The key figure to watch is growth in foreign currency reserves.
Because of the self-reinforcing nature of this system, this process must necessarily go on until a very sharp adjustment stops it. The adjustment could come in the form, as it has in the past to China and other countries, of sharply rising domestic investment (“good” version: massive infrastructure spending; “bad” version: forced corporate investment via rising inventories).
Or, it could come as rapid debt deflation, a collapse of the banking system into bad debts, a breakdown of sovereign external or domestic credit (from excess fiscal expansion), or out-of-control inflation (which is, of course, one way that the currency can adjust), or it could come as a combination of these factors.
It is possible but unlikely that the adjustment will be benign, and the longer we wait the less likely it is. This last statement is hard to prove but seems reasonable largely because of historical precedents.
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