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October 4, 2004
To Peg or Not to Peg
Today's WSJ has a brief article noting that China has pledged an eventual easing of its currency peg. Currently the peg is set at 8.28 yuan per dollar. As the article states:
Meeting with finance ministers and central bankers from the Group of Seven industrialized countries, China's top finance officials promised to push forward on financial reforms in order to adopt a more flexible exchange rate, but gave no hint when that might happen.
This reminded me of an excellent column by the late Robert L. Bartley, former editor of the Journal. In his article, "Exchange Rates: a Primer", Bartley addresses the following three myths superbly:
Myth #1: Floating currencies represent a "free market."
Myth #2: Floating exchange rates are a policy.
Myth #3: You can build prosperity by devaluing your currency.
In essence, central banks need to target something. Simply letting rates float is not a policy, but in fact is "the absence of a policy", as Bartley clearly states. If China's central bank were to stop targeting the dollar they would need to target something else (i.e. the inflation rate, a monetary aggregate, a commodity index, or back the currency with gold itself).
What U.S. exporters and some in the Bush administration seem to have been saying over the last few years is that it would be best for China to target it's trade balance with the United States. Such a target seems foolish as a trade deficit can be seen as reflecting the inclination of foreigners to invest in our country. I'll quote at length from a letter to the editor of the NYT by Don Boudreaux to clarify the point.
"[Reader Robert Lauer is] right to worry about the budget deficit, which reflects the administration’s and Congress’s recklessness. But the trade deficit is no cause for concern. It reflects foreigners’ preference to invest in American assets rather than to cash out all of their dollar holdings immediately for goods and services. This fact means not only that more investment than otherwise takes place in the U.S., but also that more foreigners have real reasons to wish the American economy well.
Your newspaper would help to end this needless fretting by referring not to the 'trade deficit' but to the 'capital-account surplus.' The two are the same thing, except that the former sounds oh so very ominous."
The job of the central bank is to control inflation, it is not to influence whether the Chinese prefer to invest in the U.S capital markets or buy U.S. goods. Additionally, it should be noted that China itself runs trade deficits with two of its major trading partners in the region:South Korea and Japan. As such, the notion that the policies of China's central bank are driven around boosting exports should be taken with a grain of salt.
Posted by Peter Mork at October 4, 2004 6:26 PM
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