China and Its Dollar Exchange Rate: A Worldwide Stabilizing Influence?

China is criticized for keeping its dollar exchange rate fairly stable when it has a large trade (saving) surplus. We argue that this criticism is misplaced in two ways. First, no predictable link exists between the exchange rate and the trade balance of an international creditor economy. Second, since 1995, the stable yuan/dollar rate has anchored China’s price level and facilitated counter cyclical fiscal policies that have smoothed its high real GDP growth at a remarkable 9 to 11 percent per year. However, cumulating financial distortions—both in China and the United States— threaten to undermine growth and stability in both economies. Unduly low U.S. interest rates and fear of RMB appreciation are provoking hot money inflows into China (and other emerging markets) causing a loss of monetary control, domestic inflation, and higher primary commodity prices worldwide. With a lag, this inflation will come back to the United States. To stem the inflow, China is forced to keep its own nominal interest rates unduly low while still sterilizing excess money issue from official reserve accumulation. The fall in the real interest rate below Wicksell’s natural rate leads to excessive investment, particularly in export oriented activities, and threatens future bad loan problems for China’s banks. Sino-American cooperation should include (1) the U.S. to exit from its zero interest rate policies and stops pressuring China to appreciate its exchange rate, and (2) China to encourage faster wage growth by ending monetary sterilization, and to end cheap credits for its export sector. These would allow China’s real (but not nominal) exchange rate to appreciate and lessen trade frictions between the two countries, while retaining their joint anchoring role for the global monetary system.