Some countries do not follow Milton Friedman’s freely floating exchange rate advice (see my recent blog). Instead, they peg their currency to the U.S. dollar. Sometimes they have logical reasons for doing so. Usually, this is because their financial markets and banking systems are not yet developed enough to allow the hedging needed by enterprises that face currency risk. This includes China. It makes sense for a country like China to wait on adopting a freely floating market determined exchange rate until their banking and financial system is ready. Given that China is now almost the world’s second largest economy, I encourage China to speed-up implementation of a modern financial system.
Given a peg, what is the correct of the level of the peg? In China’s case, there has been recent commentary from high level United States government officials that China’s peg-level is inappropriate. There are two ways that China’s economy could adjust the peg to a level that would be appropriate to its critics. One is through trade, where if China revalued their currency, their products would be more expensive and adjustment would occur. This would require, however, a reduction in GDP growth, something the Chinese will not willingly do. The other way that adjustment could occur would be if Chinese domestic demand increased. Then, some Chinese products would more easily be sold internally, maintaining their GDP growth without requiring such a large trade surplus by decreasing their saving rate.
I support dialogue with China rather than accusations that, to China, will appear as meddling with an economic policy that has internal consequences. The dialogue could include the peg-level as well as ways that China might approach stimulating domestic demand. China will likely be more interested in the domestic demand discussions than the peg-level discussions, but dialogue keeps the door open for future discussions on any topic. The Chinese household savings rate tends to be high. Part of the reason for this is due to precautionary saving. In China, there is relatively little in the way of social safety net programs like unemployment insurance, which induces precautionary saving. Domestic demand discussions with China could include ideas for implementing unemployment insurance programs and other social safety net programs. If China’s precautionary savings rate fell, domestic demand would increase. They might just move that direction, and in that case we could still maintain dialogue with China on the peg-level issue.