Ever since former Secretary of the Treasury, Henry Paulson, began his strategic dialog with China, the de facto consensus in Washington and in Europe has been to pressure China to appreciate the yuan. On the face of it, it seems an absurd thing to ask of China, which cannot afford a stronger yuan. However, a closer look reveals the method to the madness behind the consensus in the West, which is turning out to be as discredited as the Washington Consensus before it.
The expectation among the G7 countries appears to be to commit China to reforms by committing it to a stronger pegged exchange rate, because to sustain the higher rate, the rest of the G8 is expecting that China will be forced to reform. That China ought to reform is true, but is exchange rate a viable instrument to trigger Chinese reforms must be a question for serious consideration.
Exchange rates, fixed or floating, of any country are strongly linked to the country’s economic fundamentals. They are indicators of how robust the underlying economy is. The capacity of the country’s economic and political systems to efficiently allocate resources to raise its economic output and hence its standard of living constitute its economic fundamentals. Targeting the exchange rate of the Chinese currency to improve its economic fundamentals is the equivalent of targeting symptoms to cure the underlying disease.
If one were to assume that China consents to a higher fixed exchange rate for the yuan, it must increase the pace of its domestic reforms to match the higher rate so as not to collapse. And doing so could be in the interest of China in the present circumstances if it is to avoid inflation, a credit bubble or undue asset appreciation. Still, from the Chinese perspective, China may not want to commit ex ante to a higher exchange rate for the yuan without knowing if its reforms will succeed, even if it were to increase their pace for other reasons because a natural consequence of successful reforms is a stronger exchange rate, whether that be China or the United States. Simply put, China may not want to put the cart before the horse and is wisely discarding the unrest in Washington which, in the name of Washington Consensus, had done the same in the ‘90s before the Asian crisis with other countries not just in Asia, but in Latin America and Europe ― from the U.K to Russia ― spanning the breadth of Europe.
The United States should not predicate its budgets or China policy on the capacity of the Chinese or other foreigners to send their savings into U.S financial assets. It is best if China is urged to diversify its domestic investments across domestic sectors and industries to absorb the liquidity to raise its level of employment and domestic consumption and work on creating a social safety net and a more robust banking sector to reduce its level of domestic savings and to direct savings toward more gainful domestic investments to reduce its reliance on exports.
China must also prepare to face competition from its colleagues on the G20 for resource acquisitions in foreign markets in the immediate term, supported by the lending programs of international organizations and private donors, especially in oil, as the world secures its short term supplies of energy while it expects to transition out of it in the long term. The scarce non-Chinese oil in the world’s energy markets is better allocated to less oil rich economies of the world than it is to China. The same rule should also apply to the United States and Canada.
The nations of the world with at least adequate domestic oil supplies in the short run must rely on their own resources, because there is not much room for conservation or hoarding in a world of steeply rising energy demand and hence, inflation if the energy prices of 2006-2007 are any indication. China is rich in oil, gas and coal and must correlate its development and growth to first what it can domestically source. Trade in other commodities would follow the potential growth of the world’s largest economies per these constraints on energy, assuming that no country would want to either conserve or hoard other minerals which it can first domestically source.
Chinese pace of reforms under such an international arrangement of resource consumption to avoid conflicts over mutual accusations of resource grabs on the part of the large economies of the world and to raise both the allocative and technical efficiency of scarce natural resources to increase the longevity of domestic natural resource endowments would then dictate the evolution of China’s economy and its exchange rate, because the true constraint on production and hence output and growth of any country is its natural resource endowment. It may, in the end, even determine the contours of geopolitics of the rest of the world, similar to that of the European Union, as smaller countries pool resources and markets to develop their economies.
The greatest risk to China is the internal tension over the political sustainability of its one-party rule. These tensions should in and of themselves be sufficient to determine the pace of Chinese reforms as China and the Greater China region, comprising of Hong Kong, Taiwan and Mongolia attempts to integrate better, and as the G7 foreign direct investment gradually diversifies out of China to foster the dependence of the country on its own consumption and to create a better global value chain in production to more equitably distribute the benefits of globalization across all the major trading partners of any country to help China consummate its compliance with its World Trade Organization (WTO) obligations (noting duly that Russia has not been admitted yet).
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