With a stable dollar exchange rate since mid-2008, China has been very successful with its bank-financed stimulus package in overcoming the global credit crisis.

Over the past year, the surge in its domestic spending has largely offset the 40 per cent fall in 2008 of its huge export sector. GDP growth is back to a healthy 8 per cent per year, and its domestic spending sucks in imports from other Asian countries, with somewhat lesser direct effects in Europe and the United States. In 2010, China is leading the world out of the global economic downturn, which started with the banking crisis in the United States.

The stable yuan/dollar rate has been essential for the success of China’s domestic credit expansion—more than 30 per cent in 2009. Before July 2008, the renminbi was predictably appreciating at about 6 per cent per year. Unsurprisingly, hot money poured into the economy and there was no outflow of private capital to finance China’s large trade (saving) surplus. The PBC had to intervene massively to buy dollars for RMB to prevent the renminbi from ratcheting up indefinitely. The domestic monetary (inflationary) consequences were partially sterilised by issuing central bank bonds and increasing the reserve requirements on China’s commercial banks. These sterilisation measures disrupted the normal flow of bank credit within the overheating economy.

Then a ‘lucky’ accident happened. Beginning in July 2008, the global credit crunch created an unexpected burst of demand for US dollars. From July to November, the dollar—with the RMB tied to it— shot up more than 20 per cent against the euro and most other currencies. Opportunistically, the PBC then stopped further appreciations of the RMB against the dollar and reset the exchange rate at 6.83 yuan/dollar—where it remains today. For almost a year, the new exchange rate peg was sufficiently credible that hot money inflows stopped  and inflationary pressure declined. The PBC could then safely relax its constraints on the expansion of domestic bank credit—including cutting the reserve requirements of the commercial banks. Whence the minor miracle of China leading everybody out of the global recession.

But the sustainability of this expansion is threatened by the dollar’s significant fall (with the RMB tied to it) after mid 2009, a fall linked to the US Fed’s holding too long to its zero interest rate policy. Now foreigners are again complaining that the RMB (but not the dollar!) is undervalued, and speculators can borrow overly cheaply in New York to finance hot money flows into China and other emerging markets. One consequence is a huge bubble in China’s commercial and residential real estate markets, which is forcing the PBC to try to curb the expansion of domestic bank credit. Paradoxically, the solution for keeping China’s credit expansion going is for the Fed to exit from is zero interest policy—a strategy that, fortuitously, would also relax the constraint on bank credit within the United States.

Like diamonds, can the fixed yuan/dollar rate be desirable ‘forever’? Certainly not if the Fed continues to behave inappropriately. However, if American monetary policy returns to normal with the world remaining largely on a dollar standard, then having the G2 maintain a stable rate of exchange is highly advantageous. During its ‘catch up’ phase over the next decade or more, China will continue to have much higher productivity growth than the United States or Europe. But the natural balancing mechanism is for Chinese manufacturing wages to grow as fast as labor productivity. There are already signs that this may be happening. After taking a huge hit in the global crisis of 2008, Chinese wages have now recovered to where they were before the crisis—with crude estimates suggesting a 10 per cent increase in 2010.

But this happy scenario of very high growth in money wages in China is most achievable when the yuan/dollar rate remains predictably stable. If employers fear that the renminbi may ratchet upwards in the future, they will become much more reluctant to grant high wage increases in the present.

Ronald I. McKinnon is the William D. Eberle Professor of International Economics at
Stanford University.