Don't Push China Too Hard

Like the sequel to a bad movie, the United States Treasury Department and its International Monetary Fund sidekick are back in Asia playing tough cop, demanding that China liberalize its rules on international capital flows and grant foreign financial-service firms enhanced access to the Chinese market. The U.S. once again has a tax-cutting Republican president, record-setting budget and trade deficits, and a Congress demanding that the president "do something"- about China, this time. But there are reasons to believe the sequel will end differently from the 1980s original.

The first time around, Ronald Reagan's massive tax cuts created what at the time were the largest government budget deficits in U.S. history and contributed to record trade deficits and trade tensions, most acutely with Japan. Under political pressure to do something about Japan, Reagan's response was to initiate negotiations in 1983 over Japan's rules on international financial flows and the access of U.S. financial-service providers to the Japanese market. The deal accelerated Japanese capital outflow, weakening the yen and worsening trade relations. By the third reel, farce had morphed into horror flick with the treasury secretary crowing that Reagan had imposed more trade protection than any president since Herbert Hoover.

Spurred on by Congress, the U.S. Treasury then took the show on the road, playing Taiwan and South Korea, demanding capital-account liberalization, and thereby contributing to later financial mishaps in those economies.

In the run-up to the presidential elections, the U.S. Treasury is back, asking China for the same three things-a market-determined exchange rate, conflating the method of setting the exchange rate with the actual value of the currency; capital-account liberalization, especially on the outflow side; and increased access for foreign financial-service providers. Yet the political context is quite different-unlike Japan, Taiwan or Korea, China is not strategically dependent on the U.S. and will not reflexively accommodate U.S. desires.

Most observers regard the Chinese economy as overheated, and many are skeptical that recent administrative measures will be sufficient to produce the desired soft landing. Under such circumstances, a revaluation of the currency could be an advisable component of a domestic adjustment package, dampening inflation and discouraging hot-money inflows.

Yet the Chinese witnessed the Asian Crisis and have seen the havoc wreaked by premature liberalization of the capital account. The health of the Chinese banking system is questionable, and it is almost surely the case that depositors would reallocate away from Chinese institutions and renminbi-denominated instruments if they were permitted to do so. This would have the twin effects of putting downward pressure on the renminbi while at the same time undermining the stability of the Chinese banking system.

Many within the Chinese government recognize that the renminbi is undervalued, and the maintenance of the dollar peg at its current level encourages speculative capital inflows that are having a deleterious impact on macroeconomic perform-ance and the stability of the banking system. So while expressing agreement with the thrust of foreign demands during recent meetings in Washington, Chinese officials steadfastly refused to commit to any specific liberalization timetable.

Under these circumstances, a one-time step-revaluation of the renminbi of perhaps 15%-25% under the existing institutional framework would achieve the desired revaluation of the currency while buying time for continued internal reform and gradual liberalization of the capital account. The worst policy would be a small, say 2%, revaluation which would simply signal to speculators the existence of a one-way bet-the revaluation has to be big enough to convince market participants that it is unlikely to be repeated in the foreseeable future.

China emerged as the hero of the Asian Crisis by not devaluing the renminbi in the midst of the turmoil. China can now reinforce that leadership by doing the opposite: revaluing the renminbi both for its own good and to ease the adjustments of its neighbours in Asia. In the long run greater financial integration of China with the rest of the world, and greater market orientation in the determination of Chinese exchange rates, are desirable. Yet, as anyone in Asia who lived through the financial crisis of less than a decade ago knows, there are very real risks to premature liberalization of the capital account. This time around, the politics is different, and so may be the final reel of the movie.