Saturday, October 23, 2010

China's Central Bank and Currency

Earlier this week, The Wall Street Journal carried this story about a move by the Chinese central bank that sparked a sell-off in the market. The Chinese central bank had, unexpectedly, raised its short-term lending rate. Many saw this as a portent that the Chinese economy was being slowed and this would not be good for future growth as it would dampen Chinese demand for goods from around the world. This is a solid observation. But I want to raise two other points.

First, as long as the Chinese currency is tied to the U.S. dollar, or more accurately a basket of currencies that includes the U.S. dollar, the Chinese central bank is limited in its policy. Essentially, to maintain parity, it must match the policy of the countries to which it has tied its currency. This implies that as these other countries ease policy to fight recession, the booming Chinese economy is subject to a similar easing. This only invites inflation. Essentially, any nation that ties its currency to another's, must commit to a similar monetary policy. That's good if the business cycles are coincident. But when they diverge, it isn't a good idea.

Second, given the pressure on China to let the currency float, this might be a first step to do so. A higher interest rate will strengthen the currency which will help Chinese consumer buy imports and put a bit of a burden on Chinese exporters. It seems that is what many have been calling for. As a result, I'm surprised by the reaction.

As always, I welcome other insights. I do think this story is a great way to talk about monetary policy and its connection to exchange rates

1 comment:

Ed Dolan said...

You are right, the rate increase is a small, but significant indication that the Chinese central bank is allowing a little more flexibility in its currency policy, and making some small steps toward encouraging their side of the needed rebalancing. (We need to do our side too, of course, for example, by increasing government and private saving to match their hoped-for increase in consumption.) Anyone looking for additional background on how the PBoC manages its monetary policy might might find it worth checking out the slide shows attached to this post and this one .