China’s financial conundrum arises from two sources.First,its large saving (trade) surplusresults in a currency mismatch because it is an immature creditor that cannot lend in its owncurrency.Instead,foreign currency claims (largely US dollars) build up within domesticfinancial institutions.Second,economists,both American and Chinese,mistakenly attributethe surpluses to an undervalued RMB.To placate the USA,the result was a gradual andpredictable appreciation of the RMB against the dollar of 6 percent or more per year fromJuly 2005 to July 2008.Together with the fall in US interest rates since mid-2007,this onewaybet in the foreign exchanges markets not only attracted hot money inflows but inhibitedprivate capital outflows from financing China’s huge trade surplus.Therefore,the People’sBank of China had to intervene heavily to prevent the RMB from ratcheting upwards,and sobecame the country’s sole international financial intermediary as official exchange reservesexploded.Because of the currency mismatch,floating the RMB is neither feasible nor desirable,and a higher RMB would not reduce China’s trade surplus.Instead,monetary control andnormal private-sector finance for the trade surplus require a return to a credibly fixednominal RMB/USD rate similar to that which existed between 1995 and 2004.However,forany newly reset RMB/USD rate to be credible as a monetary anchor,foreign"Chinabashing"to get the RMB up must end.Then the stage would be set for fiscal expansion toboth stimulate the economy and reduce its trade surplus.
