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China in Transition

Foreign Exchange Policy Cannot Solve Structural Problems: A policy-mix approach is needed

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On July 21, 2005, China revalued the yuan by 2.1% against the U.S. dollar, while at the same time shifting from the dollar-pegging system to a managed float system. Subsequently, however, there has been no sign of the yuan revaluation pressure easing. A joint statement by Group of Seven (G7) finance ministers and central bank governors, adopted in their latest meeting held on December 2 and 3 in London, avoided using the term "revaluation" but explicitly urged China to take on "further flexible implementation" of its currency regime so as to "improve the functioning and stability of the global economy and the international monetary system." At present, however, the Chinese authorities remain cautious about revaluation and continue to make heavy market interventions to stem the pace of yuan appreciation. As one reason behind this policy, China often cites its concern that further revaluation would bankrupt many state-owned enterprises, increase unemployment and cause huge damage to domestic agriculture. However, foreign exchange policy is nothing but an instrument of macroeconomic policy and using it as a means to protect specific sectors would result in various side effects such as the expansion of internal and external imbalances.

In considering economic policy in situations where multiple goals must be pursued, the rules of Jan Tinbergen and Robert Mundell provide theoretical guidelines (note).

1) Tinbergen's rule: Achieving a multiple number of independent policy targets requires an equal number of policy instruments.
2) Mundell's rule: Each policy instrument should be assigned to a policy target on which it has greatest relative effect.

Let's say that a country is pursuing full employment (internal equilibrium) and equilibrium in the balance of international payments (external equilibrium) under the fixed exchange rate regime. According to Tinbegen's rule, to simultaneously achieve these two goals, the country needs to implement two policy instruments: fiscal policy and monetary policy. And the most effective way to do this would be to assign the fiscal policy as a means to achieve internal equilibrium and the monetary policy external equilibrium as stipulated by Mundell's rule.

Presently, China is pursuing two goals: macroeconomic stability and the protection of inefficient companies and industries. According to Tinbergen's rule, these two goals cannot be achieved simultaneously through foreign exchange policy alone; another policy instrument is needed. Meanwhile, based on Mundell's rule, such foreign exchange policy should be assigned to achieve macroeconomic stability and such issues as income disparities and structural problems should be solved through institutional reform.

Certainly, China is facing a very serious unemployment problem. In addition to a large redundant labor force in the rural areas, the number of unemployed in the urban population is rising due to the restructuring of state-owned enterprises. However, these problems are structural in nature and not attributable to macroeconomic changes, i.e. a shortfall in demand. Also, agriculture and state-owned enterprises, in neither of which China has a comparative advantage, would be forced to scale down when exposed to competition. From the viewpoint of efficiency, capital, land and human resources currently trapped in such inefficient companies and industries should be transferred to efficient sectors. This would improve the efficiency of the overall economy and upgrade the industrial structure. To help those who lost jobs amid the industrial adjustments, the government should employ more direct and effective measures such as reinforcing the social security system and supporting job training programs, rather than resorting to foreign exchange policy.

In the first place, if foreign exchange policy were the optimal policy option to solve the ongoing "structural unemployment," the Chinese authorities should not have been satisfied merely with resisting the pressure for a revaluation of the yuan; they should aggressively devalue it. In reality, however, foreign exchange policy is a tool to help stabilize the macroeconomy. Pressing to use it as a means to generate employment would be at the expense of the primary target of the policy.

The ongoing policy of containing the exchange rate at a relatively low level is already producing various side effects. To begin with, the monetary authorities need to make interventions to absorb excess foreign currency (by selling the yuan and buying the dollar) so as to suppress the rise of the exchange rate of the yuan. Consequently, the independence of monetary policy is significantly constrained. In addition, with its trade surplus rising rapidly, particularly with the U.S., China is facing intensifying trade friction with the rest of the world. To sustain economic growth while avoiding all these problems, China needs to reexamine its economic policy based on the concept of policy mix.

December 7, 2005

Note:

Jan Tinbergen, who put forward the Tinbergen rule, received the first-ever Nobel Prize in Economic Sciences in 1969. Robert Mundell, the architect of the Mundell rule, was awarded the 1999 Nobel Prize in Economic Sciences.

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