The currency war is upon us, and China and the RMB are at the centre of it. China has rejected the notion that the RMB exchange rate is the culprit of the global imbalances and so far resisted increasingly loud calls for a large RMB appreciation.
The US Congress is trying to force a larger RMB appreciation with protectionist trade legislation, but most experts believe that is unlikely and in any case would take a long time to be effective.
However, as the US is worried about growth and plans to use quantitative easing to reduce the risk of deflation, it will be able to force (real) currency adjustments upon its trading partners by printing as much of its own currency as it desires. A few other advanced economies can follow suit, notably Japan.
What will QE do? While it is not clear how effective QE might be in boosting economic growth in the US and the advanced economies, global interest rates will be kept low for a much longer time. It is all but certain that a flood of liquidity will be seeking lower risk and higher returns -- emerging markets, including China, have and will continue to be favoured destinations. As emerging currencies face appreciation pressure, some countries, notably Brazil and Thailand, have stepped up capital controls.
What can China do in the world of QE? How might it win or lose in this "currency war"? Martin Wolf, Financial Times' famous columnist, argued convincingly why the US would win the battle. Some in the Chinese community believe that since the US cannot force currency appreciation on China, the latter will win.
While China may be able to hold on to the current exchange rate policy, to gradually adjust as it pleases, that in itself can not be the sole criterion for losing or winning in the world of QE. Can China escape the unwanted consequences of QE, limit the damage of large liquidity inflows, asset bubble, and potentially gross misallocation of resources while still tightly managing currency appreciation? That will be the real test.
First, QE in the US will make China's monetary policy decision even more difficult, increasing the risk of policy error. To the extent that QE is seen as a reflection of the weakness in the US and global economy, some in China may be inclined to keep China's monetary policy accommodative for longer, to further stimulate domestic growth to compensate for weak external demand.
Moreover, interest rates may be kept low to avoid drawing in more capital flows -- concerns about capital inflows have contributed to the delay in raising interest rates so far. QE and the wall of money potentially headed for emerging markets will further weaken the stance of those who favour rate hikes and a quicker exit of the expansionary credit policy.
Maintaining a loose monetary policy and low interest rates for too long in China will not only be misguided but also dangerous. The US and other advanced economies have a lot of economic slack and may need to keep monetary policy expansionary for a prolonged period of time to help smooth their adjustments in private sector deleveraging, or fiscal consolidation, or both.
However, in China the cyclical position is very different: there is little or no slack. China should be able to sustain a relatively rapid growth of 8-9 percent even with a weak growth in advanced economies in the next couple of years.
There is no need for policy to be overly accommodative to keep growth at or close to double digit, especially as the changing demographics have reduced the pressure to create new jobs. Indeed in an economy with no slack, ample liquidity plus increasingly negative real interest (measured by nominal interest rate minus the expected inflation) could lead to misallocation of resources, inflation, and asset bubbles.
To be continued