But since then the yuan/dollar rate has moved very little, hence a sense of outrage among American and European politicians that they were deceived.

But China’s government is trapped in two important respects.

First, government officials and economists on both sides are in thrall to a false theory: that a discrete appreciation of the RMB against the dollar would predictably reduce China’s trade surplus and US trade deficit. China’s trade surplus simply reflects its net surplus of savings, and vice versa for the saving-deficient United States: there is no presumption as to how relative savings would move if the RMB was appreciated. Moreover China’s currently extremely high investment ratio has a long way to fall; perhaps any presumption should be that China’s trade balance (net saving surplus) would increase with RMB appreciation.

Second is the vital issue of exchange rate flexibility. It is impossible for the PBOC to simply let the ’market’ decide what the rate should be when at the same time it has a huge surplus. Many well-meaning commentators believe market-determined exchange flexibility is warranted. US Treasury Secretary Timothy Geithner’s speeches indicate he believes so, albeit using a much more measured and careful tone than other Americans who are involved in ‘China-bashing.’ His moderate and seemingly reasonable approach — let the yuan/dollar rate reflect ’market forces’ — is still not feasible.

Why?

China is in the historically unusual position of being an immature creditor: its own currency, the renminbi, is hardly used to finance its huge surplus. Instead the world trades on a dollar standard. We have an anomaly: the world’s largest creditor cannot finance foreign investments in RMB. This lag in international RMB use is partly because China’s domestic financial markets are immature, with interest rate restrictions and foreign exchange capital controls. World financial markets also prefer one or two national currencies for clearing international payments: currently the dominant dollar and the regionally powerful euro — although the PBOC is trying hard to encourage the RMB’s use around Asia.

The upshot is that China’s own currency is little used in lending to foreigners. Foreigners won’t, and often can’t, borrow from Chinese banks or issue RMB denominated bonds in Shanghai. China’s domestic private financial institutions cannot afford to hold the dollar-denominated trade surplus: their liabilities are in RMB and the exchange rate risk is prohibitive. China’s current surpluses at about $200 to $300 billion per year would quickly become much greater than the combined net worth of all of China’s private financial institutions.

Accordingly the intermediation of China’s saving surplus is left to the central government, which has four major tools available:

1. The accumulation of liquid reserves of foreign exchange, currently about $2.5 trillion.

2. The creation of sovereign wealth funds, like the China Investment Corporation (CIC) to invest overseas.

3. Encouraging state-owned enterprises to invest in, or partner with, foreign companies.

4. Quasi-barter aid programs in developing countries which generate a return flow of industrial materials.

China does not give ‘aid’ to African or Latin American countries in the conventional form, preferring to combine overseas investment with aid under fairly strict government control. In return for using state-owned construction companies to build large-scale infrastructure the recipient country agrees to give China a claim on a future resource stream. Because these foreign aid-investment projects are under the control of state-owned financial intermediaries, they become effectively illiquid and cannot become part of hot money flows back into China.

Each of these techniques for intermediating China’s saving surplus internationally keeps any gains in ‘safe’ government hands; they won’t be suddenly liquidated due to any external shock. This minimises, but does not eliminate, the possibility of hot money inflows back into China that could destabilise the exchange rate and make monetary control more difficult.

Tiny Singapore is also an immature creditor whose own currency is not used for international lending, and whose government also tightly controls overseas financial intermediation.  Singapore’s net saving (current account) surpluses have been persistently the world’s largest for many years. To prevent hot money flows it essentially nationalises the internal flow of saving by requiring all Singaporeans to deposit into the Singapore Provident Fund: a state-run defined-contribution pension scheme. Then Provident Fund capital is lent to two giant sovereign wealth funds: the Government Overseas Investment Corporation (GIC), which invests in fairly liquid overseas assets, and Temasek, which is more of a risk taker in foreign equities and real estate.

This is the ’Singapore Solution’ to international financial intermediation by an immature creditor country, while preserving monetary control. Singapore is too small for Americans and Europeans to complain about its disproportionately large trade surplus, and demand that the Singapore dollar be appreciated. China (and Japan before it) are not so lucky.

Surplus-saving Japan is also an immature international creditor because the yen is infrequently used to denominate international claims. But, unlike China’s or Singapore’s, Japan’s government does not dominate the international intermediation of its saving surplus as much. Large Japanese corporations make heavy overseas direct investments in autos, steel, electronics, and so on. But, in addition, Japanese banks, insurance companies, and pension funds, have become big holders of liquid assets, denominated in many foreign currencies.

This part of the Japanese system for overseas investment is vulnerable to hot money flows. Over the last 20 years, carry trades out of low yield yen assets have been commonplace with a weakening yen. These can suddenly reverse as in 2008, leaving the Japanese economy vulnerable to runs from dollars to yen.

China has mitigated — although not escaped from — the immature creditor dilemma. If it tried to float the RMB then non-state Chinese banks would not accept the risk of financing the huge trade (saving) surplus by accumulating dollar claims. There would be no net buyers of the dollars thrown off by China’s large export surplus. The RMB would spiral upward indefinitely until the PBOC was dragged back in to reset the rate. Contrary to Secretary Geithner’s suggestions, there is no market solution for the exchange rate for a large immature creditor country.

This, then, is the major challenge to the G20 meeting in Seoul: ensuring global macro-stability whilst ignoring the clamor of protectionism. A rocketing RMB is not in the global interest, and for economists or diplomats to pretend otherwise is dangerous. An integrated China following Singapore’s example is far better for the international economy than a separate and defensive China vulnerable to erratic shocks.

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

This is an edited version of Professor McKinnon’s paper. The full essay can be read here.