China’s financial conundrum and global imbalances

China’s financial conundrum arises from two sources: (1) its large trade (saving) surplusresults in a currency mismatch because it is an immature creditor that cannot lend in its own currency. Instead foreign currency claims (largely dollars) build up within domestic financialinstitutions. And (2), economists – both American and Chinese – mistakenly attribute the surpluses to an undervalued renminbi. To placate the United States, the result is a gradualappreciation of the renminbi against the dollar of 6 percent or more per year. This predictable appreciation since 2004, and the fall in US interest rates since mid 2007, not only attracts hotmoney inflows but inhibits private capital outflows from financing (compensating?) China’shuge trade surplus. This one-way bet in the foreign exchange markets can no longer be offset by relatively low interest rates in China compared to the United States, as had been the case in 2005-06. Thus, the People’s Bank of China (PBC) now must intervene heavily to prevent the renminbi from ratcheting upwards – and so becomes the country’s sole international financial intermediary.Despite massive efforts by the PBC to sterilise the monetary consequences of the reserve buildup, inflation in China is increasing, with excess liquidity that spills over into the world economy. China has been transformed from a deflationary force on American and Europeanprice levels into an inflationary one. Because of the currency mismatch, floating the RMB is neither feasible nor desirable – and a higher RMB would not reduce China’s trade surplus. Instead, monetary control and normal private-sector finance for the trade surplus require a return to a credibly fixed nominal yuan/dollar rate similar to that ...