Is China's new exchange rate regime a step forward? Faced with questions like this, economists are inclined to answers of the form "on the one hand, yes, on the other hand, no". In this case, however, we can be quite unambiguous: the answer is "we don't know".
We don't know because the authorities have still not conveyed what the new regime will entail. Their July 21 announcement described a 2% revaluation, a 0.3% daily limit on movements in the dollar rate, a shift to a basket as the reference for policy, and a statement that henceforth the currency would be more responsive to "market conditions". But since they did not specify what market conditions, it is impossible to know how much flexibility will be entailed in responding to them.
In August, the central bank then expanded the forward foreign exchange market and introduced currency swaps. This effort to provide corporates with better hedging tools suggests that greater flexibility is coming. So far, however, the authorities have been loath to let the currency move.
Thus, the new regime is equally compatible with no increase in flexibility and with an exchange rate that crawls against the dollar by 6% a month. This uncertainty in turn clouds the implications for trade and capital flows. All that's clear is that Chinese officials are keeping their options open. Under the circumstances, investors should do the same.
What is certain is that a 2% revaluation is not enough to put a dent in the problem of global imbalances. If the one-time revaluation is the end of the story, then protectionist pressures will inevitably resurface in the United States. Aware of the need for additional renminbi adjustment, investors will funnel more capital toward China. In turn this means that the problems that prevailing financial conditions pose for the Chinese construction sector and banking system have not gone away.
Further renminbi appreciation will be needed for China to maintain access to US markets. Greater flexibility will also be necessary for it to avoid creating one-way bets for investors and seeing the economy swamped by capital inflows. These adjustments are coming, like it or not.
But the longer China waits, the harder it will be to contain the excesses in its property market. Further vulnerabilities will build up in its financial system. Protectionist pressures will intensify abroad. US external indebtedness will grow, requiring an even larger adjustment in the US current account and an even larger fall of the dollar. For all these reasons, the longer a move to greater flexibility is delayed, the higher the risk of a hard landing for both China and the world.
The Chinese government worries that further appreciation will damage the profits of exporters. It worries that banks and firms will find it hard to cope with greater volatility. Most of all, China doesn't see why it should be responsible for solving the problem of the US deficit. Chinese officials are too discreet to say so, but they are essentially demanding constructive policy adjustments in the United States as a quid pro quo for greater flexibility.
They have a point. The US current account deficit is largely grown at home. If the US fails to raise its savings, its deficit will continue to widen. The dollar will then have to fall further to contain it. It is neither fair nor efficient that the consequences should be borne entirely by China.
It is politically incorrect for American economists to call for tax increases. Those doing so run the risk of getting their landing rights at Dulles Airport rescinded. But sometimes the two-handed answer is inappropriate.
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Barry Eichengreen is George C Pardee and Helen N Pardee professor of economics and political science at UC Berkeley