Defending China’s Pegged Exchange Rate

William Kucewicz tries to argue over at NRO that “China’s dollar-pegged exchange rate has been one of the bright spots of the international monetary system of the past decade”. His primary argument seems to be that a fixed exchange rate system is both a necessary and sufficient condition for price stability. The evidence he presents for this proposition, however, is less than convincing.

Kucewicz also points to Lawrence Kudlow who wrote:

A much slower China economy would take a percentage point or two off U.S. economic growth.

Kudlow is not clear where he got the estimated magnitude from, but it strikes me that he may have gotten the direction incorrect. Kudlow’s argument implicitly assumes a downward expenditure adjustment as far as Chinese aggregate demand whereas a revaluation of the Chinese currency is more likely to cause expenditure-switching away from Chinese production and towards production in other nations such as the U.S.

Update: While Kucewicz claims to have graphed China’s consumer price inflation against the nominal exchange rate, as I consult the International Financial Statistics (IFS) series 64 (consumer prices), I do not see the same alleged deflation for the late 1980’s or late 1990’s. Beyond that, I’m not sure what a comparison of the level of the yuan/$ nominal exchange rate against the rate of increase of one of the nation’s price-level is supposed to demonstrate. As an alternative, the following graph compares the ratio of China’s GDP deflator to the U.S. GDP deflator to the exchange rate (both indexed so that the 1990-level is unity) from 1978 to 2000 (the years that are covered by the IFS).

In the early part of this period, U.S. inflation exceeded Chinese inflation. However, the yuan devalued in nominal terms, which implies a rather dramatic real devaluation of the Chinese currency. For the period from 1985 to 1995, Chinese inflation exceeded U.S. inflation with the nominal devaluation of the yuan exceeding this inflation differential, which implies a continued real devaluation of the Chinese currency. Kucewicz focuses on the period since 1995, which is a period where Chinese inflation has indeed been so low that with a pegged exchange rate – the real devaluation of the Chinese currency has continued. And yet, the National Review argues against a nominal appreciation of the yuan based on a Global Monetarist mentality that does not fit the data very well.