It Takes Two To Tango

Martin Wolfs reports on the concerns President Hu Jintao of China shared on his recent trip to the United States

“The current international currency system is the product of the past.” Thus did Hu Jintao, China’s president, raise doubts about the role of the US dollar in the global monetary system on the eve of last week’s state visit to Washington. Moreover, he added, “the monetary policy of the United States has a major impact on global liquidity and capital flows and therefore, the liquidity of the US dollar should be kept at a reasonable and stable level.” He is right on both points.

In criticising US fiscal and monetary policies and, in particular, the Federal Reserve’s policy of “quantitative easing”, Mr Hu was following a well-trodden path. In the 1960s, Valéry Giscard d’Estaing, then French finance minister, complained about the dollar’s “exorbitant privilege”. John Connally, US Treasury secretary under Richard Nixon, answered when he described the dollar as “our currency, but your problem”. The French and now the Chinese desire exchange rate stability but detest the inevitable result: an open-ended commitment to buying as many dollars as the US creates. 

As Wolf later notes, the obvious solution is for China to stop purchasing dollars and allow its currency to appreciate.  China, however, is loathe to do this because it would put a damper on its export-driven growth strategy.  As a result, Chinese monetary authorities have to create more yuans to buy up the new QE2 dollars in order to maintain the crawling yuan-dollar peg.  The actual and expected increase in yuan, in turn, is contributing to the rise in China's inflation rate. In short, China is importing the Fed's QE2-driven monetary policy.  While QE2 may be good for the U.S. economy, it seems a stretch to think its optimal for an economy with 10% annual real growth.  Yet the Chinese government continues to allow Fed monetary policy to shape its domestic monetary conditions.  So before casting blame, China should remember it can always end this monetary dance with the United States and walk away.  After all, it take two to tango.

P.S. If China doesn't walk away from this monetary dance with the United States, then the resulting inflationary pressures will eventually lead to a real appreciation of the yuan that the Chinese government is trying to avoid in the first place.  One way or the other, there will ultimately come about a meaningful rebalancing of the global economy.