Stop Fixating on the Fixed Dollar-Yuan Peg
1. The yuan floats against European currencies such as the euro and the pound but has been fixed against the dollar (see chart above). If nominal exchange rates were driving trade flows as commonly alleged, then Chinese exports to the U.S. should have been growing faster than to Europe. The data show something completely different, however. In 1995, monthly Chinese exports to both destinations averaged about $2 billion. By 2006, monthly Chinese exports to both destinations were still the same, at about $17 billion. Plotted together over that entire decade, these two series look nearly identical. This is because the same real economic forces -- e.g., China's relative abundance of less-skilled labor -- have been driving both sets of trade flows.
MP: And NOT the currency values, emphasis added. In other words, if China had allowed the yuan to float against the dollar in the past, the U.S. would still have a large trade deficit with China today, because real economic forces of comparative advantage drive trade flows, not nominal prices or ex-rates.
2. Many central banks today use their sovereign power to fix a nominal short-term interest rate rather than a nominal exchange rate. The U.S. Federal Reserve targets the federal-funds rate; the European Central Bank targets the main refinancing operations rate; and the Bank of Japan targets the overnight call rate. But exchange-rate targets are by no means uncommon. Indeed, in 2005, 55.6% of the world's countries fixed their exchange rates (see chart above for the Hong Kong dollar, which is pegged to the USD). And many countries have switched their targets over time. From 1945 to 1971, for example, the Federal Reserve targeted the value of the dollar at $35 per ounce of gold.
In other words, all central banks peg, fix or target something: the U.S. Fed targets interest rates (Fed Funds rate), but used to target the money supply, many central banks have an inflation target (Canada, New Zealand, Australia), and many countries have an ex-rate target (e.g. see the pegged Hong Kong dollar in the chart above). Referring to China's policy of pegging the value of the Yuan as "currency manipulation" or "unfair" would like calling the Fed's current monetary policy unfair "interest-rate manipulation." Notice also that nobody ever complains about the hundreds of countries like Hong Kong that also target or peg their ex-rate.
3. Professor Slaughter furthers explains why it might sense for China to target its ex-rate instead of its interest rates: Chinese capital markets today lack many of the microeconomic institutions that transmit changes in short-term interest rates into the broader economy: e.g., a primary-dealer market in government debt securities and, more generally, a deep network of investment and commercial banks allocating credit guided by risk-adjusted returns. This may well be one reason the PBOC maintains its exchange-rate target: An interest-rate target might weaken its linkages to the real economy.
In other words, it makes more sense for an advanced economy like the U.S. with advanced credit markets to target ("manipulate") interest rates than a developing economy like China without advanced credit markets.