As McKinnon explains, China is in the historically unusual position of being an immature creditor. Its own currency is hardly used to finance its huge surplus. Instead the world trades on a dollar standard. As the world’s largest creditor, China 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 dollars and to a lesser extent euros for clearing international payments 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.’

The intermediation of China’s saving surplus is left to the central government. It does this through the accumulation of liquid reserves of foreign exchange (currently about $2.5 trillion); the creation of sovereign wealth funds, like the China Investment Corporation (CIC) to invest overseas; encouraging state-owned enterprises to invest in, or partner with, foreign companies; and through quasi-barter aid programs in developing countries which generate a return flow of industrial materials.

Each of these tools 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.

In many respects, the RMB looks increasingly like the Japanese yen did thirty years ago as US politicians blame the undervalued Chinese currency for America’s own economic problems. President Obama criticized China for ‘having not done enough’. The US Congress has targeted undervaluation of the RMB as an export dumping, threatening retaliatory tariffs if it is not appreciated.

The extent of the RMB’s misalignment is unclear, and designing remedies like this are both impractical and dangerous. Undervaluation is not a major factor in the US-China trade deficit and not a factor at all in America’s overall trade deficit. There is very little evidence that the RMB’s undervaluation costs the U.S. a large number of jobs. China may sometimes be a problematic economic partner, but retaliation aimed at the exchange rate will not fix anything.

So what needs to be done about the RMB?
Dealing with the issue in the multilateral context of the G20 is an appropriate start. Both the US and Chinese governments rightly favour a multilateral framework for resolving the RMB dispute. US Treasury Secretary Geithner has suggested tackling the RMB issue at the G20 meetings and this is a good idea. It will help reduce risks of confrontation between the US and China. Economic imbalances are a global issue.

China’s large current account surplus is caused mainly by pervasive distortions in factor markets, which repress costs of manufacturing production and artificially improve Chinese competitiveness. Exchange rate misalignment is only a part of the picture. Currency adjustment alone cannot correct the overall external imbalance — that would require a massive and globally disruptive exchange rate adjustment that is neither economically nor politically feasible.

Similarly, America’s damagingly low savings rate before the subprime crisis was caused by a number of factors. Depreciating the US dollar by a huge margin is unlikely to lift the US savings ratio substantially.

There is no denying that exchange rates are one important parameter determining exports, imports and, therefore, the imbalances. Hence, gradual adjustment of exchange rates, not only the RMB/US dollar rate, is one thing that has to be managed internationally. A more important agenda is the structural reforms that are necessary both in China and in North America to deal with the root causes of the imbalance problem in each national and the global economy.