March 10,2010

Are There Advantages to Governor Zhou Xiaochuan's Dollar-Peg Exit?

By Thomas H. Wilkins, CFA

Zhou Xiaochuan, the governor of the People's Bank of China, has updated his March, 2009 White Paper on Monetary Reform by advocating publically at the National People's Congress an abandonment of the peg to the US dollar.

 

What advantages would China receive from such a step?

           

By maintaining a peg, the Chinese government is forced to intervene in the yuan-dollar exchange market to supply yuan when the demand from dollars is greater than the supply. A combination of US importers, foreign direct investors, portfolio investors and hot money are buyers of yuan.

           

When the Chinese central bank supplies yuan, these monies end up in China's money supply. The central bank has a few options currently to deal with any overheating in the local money supply. It can tighten monetary policy by raising reserve requirements and/or raise interest rates in the local domestic capital markets. Or it can operate a sterilization program buying up excess money supply. These operations are boiler plate responses which satisfy the Chicago/Milton Friedman school of economics that inflation is merely a monetary phenomenon.

           

While the above options are available, what is not available are tools to dealt with a very large, or overwhelming increase in Chinese money supply, when exports increase strongly. For example February's exports increase 46% from year earlier data. Can these kinds of gains for a longer period of time be consistent with stable inflationary pressures? No! Tightening monetary policies and sterilizations have limited effects under circumstances of robust exports.

           

If China abandons the US dollar peg, then the yuan should under current circumstances increase in value. That is, China's currency should buy more oil, more iron ore and other imported items which its domestic economy needs.

           

Perhaps, what Governor Zhou is really saying is that China's policy needs to shift from favoring an increase in its foreign exchange reserves to increasing the purchasing power of it currency.  The later will have a much greater impact on moderating inflation than monetary tightening. Fixed exchange rates are joined at the hip with China's inflation risks. If this analysis is correct and if such a switch does occur, then hopefully this switch in policy will occur simultaneously with increase capital mobility for Chinese investors who wish to invest abroad.

 

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