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Steve Hanke

The plunging Shanghai stock market and the sudden reversal in the yuan’s appreciation have caused fears to spread beyond China’s borders that something is wrong with the world’s growth locomotive. There is.
The path of an economy’s nominal gross domestic product is determined by the course of its money supply. The trajectory of mainland money supply and private credit tells us why the economy is in trouble.
The annual trend rate of money supply (M2) growth is 17.1 per cent. In early 2012, M2 was growing at an annual rate of 20 per cent – well above the trend rate. It has been drifting down ever since. Today, the annual M2 growth rate is a bit above 10 per cent.
In consequence, nominal GDP will decline from its current level. This spells trouble for the mainland and the rest of the world. But why has the M2 annual growth rate declined?
Washington seems to thrive on counter-productive trade and currency wars
One factor is recent hot money capital flight. This shows up when we decompose the reserve money (state money) produced by the People’s Bank of China. The foreign exchange contribution to state money is no longer pulling it up. It is pulling it down.
How did China arrive at this point of high uncertainty and potential economic instability? A look at its exchange-rate regimes provides an explanation.
Since embracing Deng Xiaoping’s reforms in 1978, Beijing has experimented with different exchange rate regimes. Until 1994, the yuan was in an ever-depreciating phase against the US dollar. Relatively volatile readings for GDP growth and inflation were encountered.
After the yuan depreciation of 1994 and until 2005, exchange-rate fixity was the order of the day, with little movement in the yuan/dollar rate. The volatility of mainland GDP and inflation declined, with the latter largely shadowing rates in the US, given the yuan’s dollar anchor.
Beijing then entered a gradual yuan appreciation phase from 2005 to 2014. In terms of volatility, economic growth and inflation rates, the mainland’s performance has deteriorated ever since. This phase appears to have ended last month, with a small yuan depreciation.
Which begs the question, why abandon the fixity regime in 2005 when it was performing well? The answer is in response to pressure from the US and nonsensical mercantilist arguments.
The US has recorded a trade deficit in each year since 1975. The trade deficit can be reduced by some combination of lower government consumption, lower private consumption or lower private domestic investment. But, you wouldn’t know it from the Washington rhetoric.
Washington seems to thrive on counter-productive trade and currency wars that damage both the US and its trading partners.
From the early 1970s until 1995, Japan was an enemy. Mercantilists in Washington asserted that unfair Japanese trading practices caused the US trade deficit and that the deficit with Japan could be reduced if the yen appreciated against the dollar — a weak dollar policy.
Washington even tried to convince Tokyo that an ever-appreciating yen would be good for Japan. Unfortunately, the Japanese complied and the yen appreciated, moving from 360 yen to the greenback in 1971 to 80 yen in 1995.
In April 1995, then US treasury secretary Robert Rubin realised the yen’s appreciation was causing the Japanese economy to sink into a deflationary quagmire. In consequence, the US stopped arm-twisting Tokyo about the yen and Rubin began to evoke his now-famous strong-dollar mantra.
But the policy switch was too late and Japan continues to suffer from the mess created by the yen’s appreciation.
As Japan’s economy stagnated, its contribution to the increasing US trade deficit declined from a 1991 peak of almost 60 per cent to 9 per cent last year. China’s meanwhile surged from slightly more than 9 per cent in 1990 to 47 per cent in 2014. Thus the yuan replaced the yen as the mercantilists’ whipping boy.
Interestingly, the combined Japanese-Chinese contribution has actually declined from its 1991 peak of over 70 per cent to only about 56 per cent in 2014. This hasn’t stopped the mercantilists from claiming that the yuan is grossly undervalued and that this creates unfair competition and a US trade deficit with China.
Meanwhile the strength of the yuan and China’s contribution to the US trade deficit contradicts the mercantilist mantra. The yuan has appreciated in nominal terms relative to the greenback over the past 20 years, and so has the mainland contribution to the US trade deficit.
In short, the US trade deficit is the result of a US savings deficiency, not exchange rates.
So what should China do? First, Beijing should stop listening to Washington. Second, it should adopt a free-market exchange-rate regime like the currency board system in Hong Kong. Since 1983, the Hong Kong dollar/US dollar exchange rate has been fixed at 7.8 and the Hong Kong dollar has been fully convertible and fully backed by US dollar reserves.
By adopting such a fixed-rate regime, Beijing would dump instability and embrace stability.
Steve Hanke is professor of applied economics at Johns Hopkins University in Baltimore
 


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