The strategic brilliance of China's baby step

Kenneth Rogoff, Project Syndicate

Whatever the ultimate economic effects of China's first modest step towards floating its currency, one has to admire its strategic brilliance. The genius of China's mini-move (allowing the Yuan to rise 2 percent against the dollar) is that no one can tell when or what is going to happen next.

Protectionists in the United States and Europe, itching to slap huge punitive tariffs on Chinese goods, have been caught flat-footed. They want to keep bathing in press coverage, but if they push their China-bashing too far and too fast, the protectionists will be seen as hindering delicate behind-the- scenes negotiations.

But no one knows whether China's baby step is the start of something much bigger, as China's authorities hint one day and deny the next. By relenting just a little to intense global pressure to revalue its exchange rate, the Chinese leadership has masterfully stifled the growing chorus of demands to rein in its growing trade surplus. The key question, however, remains whether China is defying market forces at its own risk.

On the surface, at least, the mini-revaluation hardly seems to have compromised China's ability to bend exchange markets to its will. Foreign experts had warned that a small Yuan appreciation might be worse than none. While hardly denting global trade imbalances, a small move would bring in a flood of foreign capital, overwhelming China's currency defenses and leading to chaos. So far, that has not happened and, China once again seems to have gone its own way and proved the experts wrong.

But hold the applause. Perhaps the speculative-inflow scenario will play out, but in slow motion. After all, China is not a country where investors can just take their money in a heartbeat. It can hold the fort because it maintains one of the world's strictest regimes of exchange and capital controls. Unlike many Latin American and former Soviet-bloc countries, where similar controls are honored mainly in the breach, violating capital controls in China is virtually a capital offense.

But, over the past fifty years, when many other countries, including France and Italy, implemented draconian controls, the result was always the same: Eventually, the private sector adapted and eroded the controls' effectiveness. Whether by misreporting imports and exports or exploiting corrupt government officials (which China has in ample supply), private capital eventually starts finding its way around the controls if the incentives are strong enough.

Thus, even if the Chinese authorities can somehow keep their capital controls from hemorrhaging as the country's financial system becomes more sophisticated and decentralized, they will not be able to stop the controls from dying a death of a thousand cuts. After that, China will be able to keep its exchange rate pegged only by slavishly following U.S. interest-rate policy, which makes no sense for such a large and diverse region.

Indeed, over the longer term, the biggest concern for China is that some day money will be trying to get out. Even China's vast reserves will not be enough to stave off a painful devaluation. It is a lot easier to exit from a fixed exchange rate regime when the pressures on the currency are upwards. While it may seem hard to imagine that the speculative tide might ever turn against China, exchange-rate pressures can turn in an instant. Today's darling currency can be tomorrow's dog.

Considering China's huge and growing income inequalities, and its massive disguised rural unemployment, it is easy to imagine a period of political instability that sends investors heading for the exits. Mix in China's shaky financial system and the prospect of trade sanctions after an altercation over, say, Taiwan, and it is clear that the Yuan might not always be a one-way bet.

Last but not least, the Chinese authorities desperately need to maintain the country's breakneck economic growth in order to preserve the Communist Party's legitimacy. But, as the economy becomes richer and more complex, there will be no escaping the market imperative in internal credit allocation. Every other emerging market, even in Asia, has eventually had to cross this bridge. Indeed, the need to pursue financial liberalization to maintain growth is a central reason why middle-income countries are so prone to financial crises. That's why Chinese authorities should move to greater flexibility now, and not wait until it is too late.

So should we expect to see much bigger currency moves in China anytime soon? Should we ever expect to see wild gyrations in China's exchange rate of the sort one routinely sees in, say, the Australian dollar or the South African rand?

Neither scenario is very likely. Only fire-breathing free- market advocates, seemingly oblivious to the fact that China's shaky financial system cannot survive liberalization overnight, are calling for an extreme version of floating.

But there may well be a lot more to come over the next 12-18 months. The first round of Yuan revaluation won't be over until the currency is up against the dollar by at least 10 percent, and probably more. China's first currency move was brilliant only if it is not the last.

Kenneth Rogoff, a former chief economist of the IMF, is Professor of Economics at Harvard University.