All in a day's work

For China itself, the calculation is quite complicated. In the medium term (3 to 5 years), China needs to have more flexibility in its exchange rate policy. It is important to emphasize that it is not only the revaluation per se that matters; how it’s done also matters.

The most likely policy course is to allow a gradual, controlled rise of the currency value against the U.S. dollar. China did this between 2005 and 2008 and all the indications suggest that they may do it that way again.

But such a policy course has risks. The market consensus is that the renminbi is undervalued by 30 to 40 percent (whether this is accurate or not is irrelevant.) Thus an appreciation by 5 or 6 percent will first tell the speculators that the currency policy is now flexible and will leave them to believe that they still have much to gain by investing in renminbi-dominated assets today.

What are those assets? Mostly real estate. China is already in the middle of a huge real estate bubble. A gradual exchange rate adjustment will make it worse — and thus will make its eventual bursting even more of a calamity.

So why not move the exchange rate all the way to the market consensus level to kill the speculative expectations? This gets to some of the fundamental fragilities of the Chinese economy and I believe that this is the foremost concern in the minds of the Chinese policy makers.

Chinese export growth is labor intensive but its G.D.P. growth is capital-intensive. In the last 10 years and in 2009 in particular, Chinese G.D.P. growth has been powered by massive investments that are financed by off-budget debt of local governments.

This kind of growth gives you good economic numbers (which then invite all these criticisms of the renminbi policy) but it does not give you the things that truly matter — such as jobs and decent income growth for average Chinese.

Those export factories, which many think of as dreary sweatshops, are sources of decent income for millions; some estimates suggest that almost 100 million rural Chinese work in coastal provinces and many of them are employed in those factories. If the exchange rate is revalued by 40 percent overnight, many of those export factories will go bankrupt. That will be very unpleasant, economically, socially and politically.

This is not to argue that keeping the renminbi value artificially low is a good policy, only that the policy priority is elsewhere. China should start immediately reducing what in effect is a huge capital subsidy given to the state sector and using the money to improve the income of Chinese households.

This is the only way to rein in local government investments. There will be some unemployment but this will be better than bankrupting the export sector. China should also start de-regulation and urban reforms that will encourage the growth of its service sector (which is now abnormally small) so that job creation doesn’t fall disproportionately on the export sector.

The third priority, I believe, is to reform the currency system. Even if exchange rate flexibility is a desirable goal, what’s important is that it be carried out in the right sequence.

Without an independent interest rate policy to guide them, banks will remain handmaidens of local government bureaucrats who want to pump up growth at any cost. This also has the unfortunate effect of keeping bank lending going mainly to politically well-connected large state enterprises rather than dynamic small and medium-sized firms that are more effective at generating jobs. This tilts the economy even more towards dependence on investment and exports to sustain growth.

The government’s desire to maintain a stable exchange rate relative to the dollar means that China is effectively importing U.S. monetary policy, constraining short-term policies and hampering longer-term adjustment.

For instance, even though U.S. interest rates are likely to remain low as the economy here is still weak, China really ought to raise interest rates now to help cool off bank credit expansion, prick incipient asset price bubbles and reduce the risks of inflation.

A flexible exchange rate would allow China to run a monetary policy better suited to its own economic circumstances. This, in turn, would facilitate banking reforms and help to shift credit flows towards private sector firms — both in manufacturing and services — that can generate more jobs.

And a currency appreciation would increase the purchasing power of Chinese households as imports become cheaper. This would boost household consumption, making the Chinese economy more balanced and less dependent on exports or investment.

These changes will ultimately be good for China itself and the U.S., with China able to take in more imports from the U.S. and the rest of the world. A more balanced pattern of growth in China will also aid the global rebalancing effort by creating room for other emerging market economies to allow their currencies to appreciate without fear of losing competitiveness to China.