Thursday, August 11, 2005

But we can't give you the recipe 

An advantage of fixed exchange rates is their transparency. You know what the central bank of a country is planning, and by simply looking at a newspaper you know if they're good on their word. Whether or not it had bad effects on the U.S., China's fixed exchange rate at least gave us a fairly clear idea what they were doing with monetary policy.

We now have a situation where we're told they are not pegging to the dollar but referring to a basket of currencies. Only yesterday did we learn what's in the basket.
Zhou Xiaochuan, governor of the People's Bank of China (PBoC), China's central bank, said for the first time on August 10 that the US dollar, euro, Japanese yen and South Korean won are the primary constituents of the basket of currencies that will act as a reference for the yuan exchange rate. ...

"The countries and regions and their currencies that take a comparatively major position in China's foreign economic activities concerning foreign trade, foreign debt and foreign direct investment will be taken into account when the central bank adjusts the exchange rate of the Chinese yuan," Zhou said. "They will constitute the basket of currencies and be weighted accordingly ... The United States, European Union, Japan and the Republic of Korea are China's most important trade partners, so their currencies naturally [became] the main currencies in the basket," he said. Singapore, Britain, Malaysia, Russia, Australia, Thailand and Canada also have important roles in China's foreign trade, so their currencies are important for the yuan exchange rate as well.
Hong Kong and Taiwan are not mentioned, but since they are pegged exchange rates -- Hong Kong having a currency board arrangement that provides a hard peg to the dollar -- they're covered by the dollar in the basket.

An editorial note in this Asian Times article suggests that the reason the shares of the various currencies in the basket are kept secret is to discourage speculators. Xinhua reports...
Some experts believe it is wise for the country not to publicize all the currencies in the basket as well as their shares, which will help the central bank better regulate and manage the exchange rate.
...but that tosses aside the transparency of central bank policy.

A further lack of responsibility is pointed out by former IMF director of research Ken Rogoff in last Monday's Bangkok Post.
Perhaps the speculative-inflow scenario will play out, but in slow motion. After all, China is not a country where investors can just take their money in a heartbeat. It can hold the fort because it maintains one of the world's strictest regimes of exchange and capital controls. Violating capital controls in China is virtually a capital offence.

But, over the past fifty years, when many other countries implemented draconian controls, the result was always the same, eventually, the private sector adapted and eroded the controls effectiveness. Whether by misreporting imports and exports or exploiting corrupt government officials (which China has in ample supply), private capital eventually starts finding its way around the controls if the incentives are strong enough.

Thus, even if the Chinese authorities can somehow keep their capital controls from haemorrhaging as the country's financial system becomes more sophisticated and decentralised, they will not be able to stop the controls from dying a death of a thousand cuts. After that, China will be able to keep its exchange rate pegged only by slavishly following US interest-rate policy, which makes no sense for such a large and diverse region.
I agree that it's far too soon to tell if this new regime for China is working.