For the good of the global economy, China must end its fixed-rate currency policy

By Money Matters Editors

Memo to China: let your currency, the yuan, float, or be determined by market forces, in stages.

If you undertake the above measure, you’ll help your economy, and the global economy.

If you don’t, difficult conditions are up ahead for your economy, and the world’s, as well. Here’s why:

Keeping the yuan fixed at roughly 6.83 yuan to the U.S. dollar is only hastening  the day when China will have to transition to a more domestic-consumption-based economy. That’s because China’s artificially-cheap international products that stem from that fixed-rate are increasing protectionist sentiment in the United States, a key customer nation. Conversely, allowing the yuan to appreciate, in stages, may quell protectionist sentiment that’s building in Congress, enabling China to transition to a consumer economy more gradually. Failing to do so may result in Congressional tariff on China.

Second, keeping the yuan fixed is importing inflation to China: as the dollar falls against the euro, pound etc., the yuan falls against them, as well. The fixed yuan will only hamper efforts to achieve price stability.

In the months and quarters ahead, the U.S. will do its part to support the dollar: it doesn’t want to see the yuan appreciate to 3 or 2 to the dollar. The U.S. has increased its savings rate and decreased its consumption of international goods, particularly goods from China, supporting the dollar. And in the months ahead, health care reform legislation will help cut the long-term U.S. budget deficit. Additional spending cuts and tax increases in the year ahead will cut the U.S. budget deficit further, providing more support for the dollar.

Finally, once the U.S. economic expansion is self-sustaining, the U.S. Federal Reserve will begin to raise short-term interest rates, which should boost the buck even more.

Hence, together, China and the U.S. can eliminate three structural imbalances in the world – a lack of savings and large budget deficits in the U.S. and excess capital in China, and in the process help put the global economy on a balanced, sustainable growth track. But one step must be undertaken: China must allow the yuan to float, or be determined by market forces, in stages.