China’s paramount leader, President Xi, has vowed that stability is his top priority. Interestingly, Xi echoes Karl Schiller, who was the German finance minister from 1966 until 1972. As Schiller put it, “Stability is not everything, but without stability, everything is nothing.”
Well, China, a country that has experimented with different types of exchange rate regimes, was stable during the 1994-2005 period. That’s when exchange rate fixity was the order of the day. Indeed, the renminbi was firmly anchored to the US dollar, with little movement in the RMB/USD exchange rate.
China’s growth was stable and strong, and its inflation rate shadowed that of the US.
Then on July 21, 2005, under pressure from the US and on the advice of the International Monetary Fund (IMF), China dumped its embrace of exchange rate fixity and adopted a flexible exchange rate arrangement. I, along with Nobel Prize winner Robert Mundell and the late Ronald McKinnon, objected to this change and subsequently joined Renmin University in Beijing as senior advisers to Renmin’s International Monetary Institute.
We anticipated that instability would accompany the introduction of exchange rate flexibility.
Never mind, the US and IMF ruled the day. Their thinking was that if flexibility was introduced, China would be forced to adopt an ever-appreciating renminbi policy.
This would have mirrored Japan’s post Second World War ever-appreciating yen policy. Well, contrary to what Washington wished for, the renminbi has been up, down, and sideways in the era of flexibility.
China’s money supply growth measured by M2 has also been all over the place since exchange rate flexibility was introduced. The average annual growth rate for this broad money metric has been 15.75 per cent since 2003. But, the money supply has zigged and zagged, reaching a high of almost 30 per cent in the fall of 2009 and a low of 9.03 per cent today.
The current “low” rate of broad money growth is a result of a clamp down on shadow banking, curbs on local government debt, limits on real estate lending, and new controls on wealth management products. These curbs were imposed following the huge 2015-16 spike in credit to the private sector. The spike of private credit growth was well above the trend rate of growth (16.36 per cent).
Broad money growth rates are important, because, according to the monetarist model for national income determination, changes in the money supply, broadly determined, drive changes in nominal national income. Sure enough, the nominal changes in domestic demand in China follow changes in broad money.
The current level of domestic demand is below its trend rate, and the Economist Intelligence Unit projects that nominal domestic demand is headed down. Other important indicators confirm that the slowdown has already taken hold.
The elephant in the room, China’s infrastructure build, has already ground to a halt.
The prospect of a slowdown was apparently too much for President Xi to bear. So, he ordered the authorities to loosen up on the monetary squeeze. The pretence for this change was the US-China trade war.
But in reality, President Xi’s change of heart has more to do with the dramatic surge in bankruptcies and sharp reduction in infrastructure investment, which has fuelled much of China’s growth.
We will have to wait and see whether President Xi’s gamble will pay off, or whether it’s too little, too late. At this point, the only thing we know is that exchange rate flexibility has spawned imbalances and instability, Xi’s nightmare. And, this is bad news not only for China, the world’s locomotive, but for the international markets, too.
— The writer is Professor of Applied Economics at Johns Hopkins University.
