Distinguished Speaker Seminar

Ronald McKinnon, William D. Eberle Professor of International Economics at Stanford University, addressed ADBI staff and invited guests on why China should keep its exchange rate pegged to the dollar, drawing on Japan's experience from 1971 through the early 1990s.

The pressure to appreciate the renminbi is coming from the United States, which is experiencing a large trade deficit with China, much as it had with Japan 30 years ago. Politicians, and many economists, argue that letting the renminbi appreciate against the dollar will raise the price of China's exports and help reduce this deficit. Professor McKinnon expressed concern about this approach, noting that "as with Japan's earlier experience, exchange rate appreciation, or the threat of it, causes macroeconomic distress without having any predictable affect on the trade surpluses of creditor economies." He went on to say that an appreciation is both "misplaced and dangerous" as it does not address the root cause of the problem (i.e. US savings deficiency) and may hurt the Chinese economy by triggering a deflationary spiral. McKinnon pointed to the Japanese experience of "serial appreciation" which did not "obviously affect" its trade balance and caused Japan to go into just such a deflationary spiral and liquidity trap.

Many Asian countries, notably China and Japan, suffer from "conflicted virtue" according to McKinnon. These countries are "virtuous" for having high savings which the US uses to fund its trade deficit. This "virtue" results in the build up of dollar claims that subsequently lead to pressure to appreciate the lending country's currency. Creditor countries are thus "conflicted", worrying that such an appreciation will lead to deflation. In addition, McKinnon asserted, currency appreciation can lead to wage growth slumps and a negative risk premium.

McKinnon argued that policy makers and economists alike must "get rid of the notion you can manipulate exchange rates to handle trade imbalances". Instead exchange rates should be thought of as "... instruments of monetary control." He stated that a monetary approach to exchange rate policy, which focuses on stabilizing the domestic price level, should be pursued. The experience of the Yuan/Dollar exchange rate between 1994 and 2005 provides anecdotal evidence that a fixed exchange rate can lead to stable prices at home, Professor McKinnon said.

McKinnon stated that floating the renminbi "... would be a big mistake – leading to an upward spiral in China's exchange rate, deflation (particularly in agricultural prices), and a zero-interest liquidity trap in the Japanese mode." The 'biggest threat currently is not the sustainability [of the US trade deficit] in a financial sense, but protectionism in the US' McKinnon concluded. However, given that politicians tend to focus on exchange rates, it is therefore important to get "... these international imbalances smoothed out but not with an exchange rate mechanism."