（Songzuo Xiang's paper on OMFIF Bulletin, April 1, 2010)

Renmnbi revaluation debate leads in wrong directions:Monetary reform not scapegoat searching is the answer

By Songzuo Xiang

There is a great deal of noise – but not much illumination – about the renminbi exchange rate. The debate about the renminbi’s valuation would be a great deal more helpful if it was guided by a better understanding of the Chinese economy. Many arguments have been advanced since 2002 to press for a renminbi appreciation. Very few, however, have any solid theoretical rationale or empirical support. Imperfect or biased explanations have focused unwarranted blame on the renminbi exchange rate as the main cause of the shortcomings of the international monetary system This diverts attention from the real failures and from the  opportunity to reform the system.

The most popular argument for a revaluation of the renmninbi is that it would help restore global economic equilibrium, which the US Treasury Department appears to define largely in terms of US trade deficits and balance of payments deficits. To my mind, that is a rather narrow definition. And it pays insufficient attention to the reality that, under the current dollar-dominated system, the core reserve-issuing country (that is, the US) must have balance of payments deficits in order to supply reserve money, just as South Africa under the Gold Standard had to have balance of payments deficits to allow gold exports.

We must remember that since the breakdown of Bretton Woods System in 1971, world foreign reserve assets have increased roughly 160-fold, from $45bn to $7.5trn, more than 70% of which has been supplied by US balance of payments deficits. Levels of dollar exchange rates, whether in the 1970s against the D-Mark, in the 1980s against the yen, or now against the renminbi, have very little to do with US deficits and so-called ‘global imbalances.’ If US officials say they should correct their deficits as a means of rebalancing the world economy, then the best way of achieving this would be to take steps to abandon dollar system and accept other currency or currencies as international reserve money.

The large Chinese trade and current account surpluses do of course deserve some attention. But it is important to point out that at least 50% of total Chinese exports are manufactured products with foreign intermediate products as inputs. At least 60% of total Chinese exports are supplied by joint ventures and foreign companies. The Chinese trade surplus is the result of the international division of labor. China’s huge foreign reserve assets (now almost $2.4trn) stem part from the trade surplus, and part from speculative capital inflows, which to a large extent are due to expectations of a renminbi appreciation caused by foreign political pressure, particularly from the US.

There appears to be a more plausible argument for renminbi appreciation, namely that the People’s Bank of China needs an ultimately flexible exchange rate policy and currency appreciation as a means of carrying out an independent monetary policy and controlling  inflation. This argument rests on the celebrated thesis of the ‘impossible trinity,’ under a country cannot simultaneously run an independent monetary policy while maintaining exchange rate stability  and unrestricted capital flows vis-à-vis  the outside world.  However, intensive empirical research on Chinese monetary developments since 2002 (including research by Peterson Institute for International Economics) has found no persuasive evidence of a relationship between renminbi appreciation and monetary independence. Moreover, the monetary experiences of many Asian and South American emerging economies since the 1980s (particularly after the Asian financial crisis of 1997-98) have quite often contradicted the view that exchange rates flexibility allows monetary independence.

Rather than going down false trails, we should learn the right lessons from the global financial crisis and mobilize forces to rethink and reform the international monetary system. I believe the asymmetry of the dollar-dominated monetary standard, and the fallacies associated floating exchange rates, are two fundamental reasons for recurrent financial crises and the phenomenon of global imbalances. There has been a sharp contrast between the relative financial stability of the Bretton Woods fixed exchange rates era and the extraordinary volatility of flexible exchange rates after the final breakdown of Bretton Woods in 1973. Although there were monetary crises between 1945 and 1971, these were confined only to the industrialized economies; between 1973 and today, the number of crises has become larger and they have become more widespread.

The increasing politicization of the renminbi exchange rate and a search for scapegoats rather than solutions point us in the wrong direction. This mindset impairs prospects for world economic recovery. No-one pretends that reconstructing the monetary architecture for a stable and prosperous world economy will be an easy task. The Chinese authorities as well as the Americans, Europeans and other regions all have a part to play in this. But we should make a start in this regard in a down-to-earth manner that is free from finger-pointing politicking and polemics. The Official Monetary and Financial Institutions Forum provides a useful platform that can help progress on this agenda. I am looking forward to further discussions that can help us to achieve the goal of a new global monetary order

Songzuo Xiang

Member of Advisory Board, Official Monetary and Financial Institutions Forum(OMFIF)

Senior Fellow, Center for International Monetary Research, Renmin University of China