The need to adhere to the clear rule for the basket peg - at least internally for PBC

In today's WSJ Op-ed Stanford Professor Ronald McKinnon lamented on China's yielding to unreasonable pressure from US Congress, comparing this to China's yielding to opium import in the 1840s. He listed five "negative comments" on the new basket peg
  1. With the fixed exchange rate now unhinged, the People's Bank of China (PBC) will have to come up with a new anchor or rule that governs monetary policy. None was announced when the PBC let the exchange rate go. Will the PBC institute an internal inflation target? What will be the financial instruments it uses to achieve this target?
  2. Because China's inflation rate had converged to the American level (or slightly less), any substantial sustained appreciation of the RMB (the Americans want 20% to 25%) will drive China into deflation -- preceded by a slowdown in exports, domestic investment, and GDP growth more generally.
  3. If the PBC allows only small appreciations (as with the 2% appreciation announced on July 21) with the threat of more appreciations to follow, then hot money inflows will accelerate. If China attempts further financial liberalization such as interest rate decontrol, open market interest rates in China will be forced toward zero as arbitrageurs bet on a higher future value of the RMB. China is already very close to falling into a zero-interest liquidity trap much like Japan's -- the short-term interbank rate in Shanghai has fallen toward 1%. In a zero-interest liquidity trap, the PBC (like the Bank of Japan before it) would become helpless to combat deflationary pressure.
  4. Any appreciations, whether large and discrete or small and step-by-step, will have no predictable effect on China's trade surplus. The slowdown in economic growth will reduce China's demand for imports even as exports fall so that the effect on its net trade balance is indeterminate.
  5. Because the effect of appreciations on China's trade surplus will be ambiguous, American protectionists will come back again and again to complain that any appreciation is not big enough. So abandoning the "traditional" rate of 8.28 yuan per dollar will, at best, result in only a temporary relaxation of foreign pressure on China.

He also said, "Thanks in large part to pressure from our lawmakers in Washington, China is now in a nebulous no man's land regarding its monetary and exchange rate policies. Instead of clear guidelines with a well-defined monetary anchor, its macro economic decision-making will be ad hoc and anybody's guess - as was (and still is) true for Japan."

He is of course correct in that US pressure has been irrational, and China should not yield to it. He is also correct in his deduction, but only if his assumption that the People's Bank of China (PBC) does not have "a new anchor or rule that governs monetary policy" is true. But PBC does have clear policy kept to themselves, in my view, which is confirmed by Zhou's recent speech. As long as China adheres to the "translucent box" rules to eliminate human decision, and restrains from changing the peg anchor (less than 2.5% p.a.), Professor McKinnon's worries (1-4) should be largely addressed. Therefore, PBC needs to pay attention to Professor McKinnon's comments and go through this check-list daily when managing the basket peg.

As for his point (5), let's hope the collective wisdom of the American people (who are also the consumers), and bright minds such as Professor McKinnon's would together win over the irrational protectionists.


Anon said...

If the rule means "formula", then whether it's internal or not is irrelevant---outside people will work out the formula after a few weeks from the variation of RMB. And if the goal is to defeat the hot money, then PBC should never follow a clear rule, i.e., a pure strategy. It must be a fixed strategy. In other words, the rule should be "no rule".

Sun Bin said...

True, but I think the "rules" are more than just "formulae". The existence of the gaps will make it difficult enough for speculators to do regression until a larger amount of data is accumulated (i.e., for a period until the basket weights are changed -- e.g. semi-annually, which is probably what Singporeans estimated how long it would take for the formula to be reverse engineered by regression to the required accuracy). IMO it is more important to enforce an objective rule to eliminate human error (and human decision) than the need to fight speculators -- speculators usually bet with the market trend and they are more benign than high-ego bureaucrats. So the goal is to establish a sustainable currency board such that healthy economic policies can be executed. (concern about speculator should be secondary, in my view)