Writing for the opinion page of today's Wall Street Journal, Stanford University's Ronald McKinnon explains what he doesn't like about the path the Chinese central bank has set out upon:
(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.
Point (2) was addressed in the Cleveland Fed's 2002 Annual Report essay titled "Deflation":
Those who believe that deflation is everywhere and always associated with recession must account for the situation in the People’s Republic of China, where real GDP has been growing between 6 percent and 8 percent per annum for several years, despite deflation.
... the contrasts between Japan and China—a struggling, mature economy versus a
robust, developing country with a relatively small capital stock (hence, high return to investment)— are central to our assessment of the impact of falling prices.
The main point was that mild deflations are only problematic when nominal interest rates are extremely low. McKinnon makes the argument (in point (3)) that this is the relevant case in China today, but there is another reason, in my mind, to be skeptical about the deflation story.
The monetary impact of maintaining an exchange-rate policy that pegs the nominal interest rate below the level where a free float would take it is an increase in the domestic money supply. I will stick close to my essentially monetarist roots and point out that therein lie the seeds of domestic inflationary pressures. One interpretation of why it was prudent for the Chinese to move as they did is that it was necessary to keep these inflationary pressures from emerging. Thus, there is an argument to be made that maintaining central bank credibility to sustain low rates of inflation -- the issue in McKinnon's first point -- required the sort of adjustment that the Chinese actually implemented.
I might agree with point (5) -- but that should be our problem, not theirs.