China’s Financial System and Monetary Policies: The Impact on U.S. Exchange Rates, Capital Markets, and Interest Rates

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Mr. Chairman and Members of the Commission, thank you for thisopportunity to discuss China's financial system and monetarypolicy, their impact on the United States, and the relationshipbetween China's financial system and domestic Chinese politics.These are complex issues and I will only touch the surface today,but I hope to address the core ideas and offer some policyrecommendations consistent with a liberal international economicorder-which I believe is essential for U.S. economic security andChina's peaceful development.

Major Questions

Let me begin by briefly addressing the four questions you askedmembers of this panel-"The Macroeconomic Impact of ChineseFinancial Policies on the United States" -to consider.

1. Is the present equilibrium sustainable? That is, arewe in a New Bretton Woods Era? Or, do we need a new Plaza-LouvreAgreement to manage adjustment?

The "present equilibrium" is an equilibrium only in the sense ofa status quo. In an economic sense, it is a disequilibrium due tofinancial repression in China and government profligacy in theUnited States. The status quo is sustainable only to the extentthat China and the rest of the world are willing to accumulatedollar assets to finance our twin deficits.

We may be in a "New Bretton Woods Era" in the sense that Chinaand other Asian countries peg their currencies to the dollar as akey reserve currency, but the analogy to the original Bretton Woodssystem is misplaced. There is no golden anchor in the presentsystem of fiat monies, and private capital flows and floatingexchange rates have fundamentally changed the nature of the globalfinancial architecture.1 TheInternational Monetary Fund (IMF) has been searching for a newidentity since the collapse of the Bretton Woods system of "fixedbut adjustable" exchange rates in the fall of 1971 when the UnitedStates closed the gold window and suspended convertibility. TheMexican peso crisis in 1994-95 and the Asian currency crisis in1997-98 resulted in large part because of excessive domesticmonetary growth and pegged exchange rate systems in the crisiscountries.2 Since that timemany emerging market countries have adopted inflation targeting andfloating exchange rates. Trying to form a new IMF-led system ofmanaged exchange rates with central bank intervention would be astep backward rather than forward.3

We do not need a new Plaza-Louvre Agreement to manage globalimbalances. Just as the negotiations approach to tradeliberalization gets bogged down in the global bureaucracy,government-led coordination of exchange rates is apt to fare nobetter. There are many more players today than in the 1980s, whenChina was still in the minor league. A surer route to successfuladjustment is for each country to focus on monetary stability,reduce the size and scope of government, and expand markets.International agreements are difficult to enforce, and no onereally knows what the correct array of exchange rates should be.Millions of decentralized traders in the foreign exchange marketsare much better at discovering relative prices than governmentofficials who are prone to protect special interest groups. TheUnited States, for example, wants the yuan (also known as therenminbi [RMB]) to float-but only in one direction.

2. What are the chances for an orderly vs. disorderlyadjustment? What are the implications of each for U.S. capitalmarkets?

If China continues to open its capital markets and to make itsexchange rate regime more flexible, it will eventually be able touse monetary policy to achieve long-run pricestability.4 At present, thePeople's Bank of China (PBC) must buy up dollars (supply RMB) topeg the RMB to the dollar and then withdraw excess liquidity byselling securities primarily to state-owned banks. This"sterilization" process puts upward pressure on interest rates,which if allowed to increase would attract additional capitalinflows. The PBC thus has an incentive under the current system tocontrol interest rates and rely on administrative means to managemoney and credit growth. But the longer this system persists, thelarger the PBC's foreign exchange reserves become and the morepressure there is for an appreciation of the RMB/dollar rate.

The July 21, 2005 revaluation and a number of changes in theinstitutional setting to establish new mechanisms for market makersand hedging operations are steps in the right direction. Financialliberalization will take time, and China will move at her own pace.The United States should be patient and realistic. Most of thecosts of China's undervalued currency are borne by the Chinesepeople. Placing prohibitively high tariffs on Chinese goods untilthe RMB/dollar rate is allowed to appreciate substantially is not arealistic option. It would unjustly tax American consumers, notcorrect the U.S. overall current account deficit (or even ourbilateral trade deficit with China), and slowliberalization.5

Adjustment requires that China not only allow greaterflexibility in the exchange rate but also allow the Chinese peopleto freely convert the RMB into whatever currencies or assets theychoose. Capital freedom is an important human right and would helpundermine the Chinese Communist Party's monopoly on power bystrengthening private property rights. A more liberal internationaleconomic order is a more flexible one based on market-determinedprices, sound money, and the rule of law. We should help China movein that direction not by threats but by example. The U.S.government should begin by reducing its excessive spending andremoving onerous taxes on saving and investment.

An orderly adjustment based on market-liberal principles wouldhelp ease the costs to the global economy and to the United Statesin particular. Keeping our markets open sends an important signalto the rest of the world, and getting our fiscal house in order-bytrimming the size of government and by real tax reform-would showthat we mean business. Reverting to protectionism, on the otherhand, would have a negative impact on the global financial system,and adjustment would be slower and more costly.6

3. What is the likelihood that China will seek todiversify its foreign currency holdings? How would they do so? Whatwould be the consequences?

The composition of China's foreign exchange reserves is a statesecret, but a reasonable estimate is that about 80 percent ofChina's $941 billion of reserves are held in dollar-denominatedassets, especially U.S. government bonds. Any sizeable one-offrevaluation of the RMB/dollar rate would impose heavy losses onChina. Other Asian central banks would also suffer losses on theirdollar reserves as the trade-weighted value of the dollar fell. Noone wants to be the last to diversify out of dollars. If the eurobecomes more desirable as a reserve currency, the PBC and otherAsian central banks can be expected to hold more euros and fewerdollars in their portfolios.

The future of the dollar will be precarious if the United Statescontinues to run large budget deficits and fails to address itshuge unfunded liabilities. Foreign central banks would not wait fordoomsday; they would begin to diversify now. Markets are ruled byexpectations, so it is crucial for the United States to begintaking positive steps to get its own house in order-and to reaffirmits commitment to economic liberalism.

For its part, China can help restore global balances by movingtoward a more flexible exchange rate regime and liberalizingcapital outflows so that there will be less pressure by the PBC toaccumulate foreign reserves. Delaying adjustment means fasteraccumulation of reserves, greater risk of capital losses by holdingdollar assets, and a stronger incentive to diversify. Indeed, in arecent report, China's National Bureau of Statistics recommendedthat the PBC should increase the pace of diversification to reducefuture capital loses from overexposure to the dollar.7

If China does begin to increase the pace of diversification andthe United States does not effectively resolve its long-term fiscalimbalance, the result would be higher U.S. interest rates, crowdingout of private investment, and a decline in stock prices.

4. What are the likely consequences of a failure toaddress global current account imbalances?

The most serious consequences of not addressing the globalcurrent account imbalances would be the persistence of marketsocialism in China and creeping socialism in the United States. Thefailure to address global imbalances means the failure to accepteconomic liberalism. China needs to move toward a market-liberalorder, which means it needs a rule of law that protects persons andproperty, and the United States needs to resist protectionism andreduce the size and scope of government.

While it is useful to consider the macroeconomic impact ofChinese financial policies on the United States, it is well toremember that China is still a relatively small economy (the U.S.federal budget alone is larger than China's GDP). What matters mostfor the U.S. economy is to pursue sound monetary and fiscalpolicies at home. If we follow such policies and maintain an opentrading system, U.S. prosperity will continue.

China's Repressed Financial System

There is no doubt that China's financial system is repressed:capital controls limit freedom of choice, the exchange rate isundervalued and distorted by massive government intervention,interest rates are heavily regulated, the private sector isdiscriminated against in favor of state-owned enterprises (SOEs),banks and security firms are mostly government owned andcontrolled, and corruption is rampant.

China has the most restricted capital markets in Asia. Portfolioinvestments are heavily controlled, as are most other capitalaccount transactions. Changes are occurring, such as more lenienttreatment of qualified foreign and domestic institutionalinvestors, but much remains to be done.8 A ranking of Asian countries based on the UBScapital restrictiveness index indicates that China has a long wayto go before it reaches the degree of capital freedom enjoyed bytop-rated Hong Kong (Figure 1).9

Media Name: 08222006figure1.bmp

Source: Anderson, "How to Think About China (Part 6),"November 28, 2005, p. 23, based on CEIC, IMF, and UBSestimates.

By suppressing two key macroeconomic prices-the interest rateand the exchange rate-and by failing to privatize financial marketsand allow capital freedom, China's leaders have given upflexibility and efficiency to ensure that the Chinese CommunistParty (CCP) retains its grip on power. The goal is to build a"socialist market economy," not a genuine free market based onprivate property rights and the rule of law. Restricting economicfreedom, including the free flow of information essential toefficient capital markets, inevitably retards both personal andpolitical freedom.

China's financial repression means the PBC cannot have anindependent monetary policy aimed at achieving long-run pricestability. Rather, the PBC has a schizophrenic policy aimed atmanaging both the exchange rate and the price level. Such a policyis untenable in the long run if China wants to become a world-classfinancial center with capital freedom. Moreover, as the tradeaccount grows, it becomes more difficult to control capital inflowsand to "sterilize" them by selling central bank bills to preventnew base money (created when the PBC buys dollars and other foreigncurrencies) from creating excessive money and creditgrowth.10

The CCP faces a dilemma: it can either maintain the status quoby suppressing capital freedom to retain its grip on power or itcan gradually normalize China's capital markets and risk losingpower. The best way to help China move toward market liberalism,and away from the status quo, is to stick to a policy of engagementrather than succumb to destructive protectionism.

The Case for Economic Liberalism

Engagement does not mean dictating what the RMB/dollar exchangerate should be or calling for a new Plaza-Louvre type agreement tocorrect global imbalances. When the Group of Five IndustrializedNations, the G-5 (United States, United Kingdom, Japan, Germany,and France) met in 1985 to agree on collective action to lower theforeign exchange value of the dollar, China was not a factor. ThePBC's foreign exchange reserves were only $12.7 billion (see Figure2), and China's overall current account was roughly in balance.Intervention in the foreign exchange markets and various changes infiscal policies in the G-5 did help to bring the dollar's valuedown, but the U.S. current account deficit still reached a peak of3.4 percent of GDP in 1987, at which time the G-6 met in Paris toreverse course and intervene to stem the dollar'sslide.11

Currency intervention is often sterilized and has no permanenteffect on the real exchange rate. The dollar had already begun tofall against the major currencies before the Plaza Accord.The 1985 agreement accelerated that process. The Bank of Japan(BOJ), however, engaged in sterilization to offset the dollar sales(yen withdrawals), limiting the impact on the yen/dollar rate.After the 1987 accord, the BOJ bought dollars and allowed themonetary base to grow rapidly, creating the bubble economy. Thebubble burst in 1990 after the BOJ sharply cut money growth inmid-1989. The lesson is that exchange rate intervention can wreakmonetary havoc. The countries that suffered the most from the Asianfinancial crisis were those that had mistaken monetarypolicy.12 As JohnGreenwood, chief economist for Invesco Asia, Ltd., observed, "Thegeneral lesson is that to control money and credit growth withinreasonable ranges that are compatible with low inflation in thelonger run, the external value of the currency must be free toadjust-especially upwards."13

Today, the U.S. current account deficit has risen to more than 6percent of GDP, China is the world's third largest trading nation,and Asian central banks play an important role in financing theU.S. budget deficit. A new Plaza accord would require a much largergroup to negotiate-the Group of 20-without any credible enforcementmechanism. William Cline of the Institute for InternationalEconomics has argued that emerging market economies in Asia canovercome the "prisoner's dilemma" by jointly agreeing to allowtheir currencies to appreciate against the dollar. The extent ofoverall appreciation would then be much smaller than if eachcountry acted alone. He would also have the Federal Reserve,European Central Bank, and Bank of Japan intervene in the foreignexchange market to push the dollar lower.14

Media Name: 08222006-figure2.png

A negotiated approach to resolving trade imbalances presumesthat "experts" know the relevant market-clearing exchange rates andthat governments can agree to enforce them-neither of which hasproven to be true. Financial markets are much more complex now thenin the 1980s, and private capital flows swamp official flows. Anyexchange rate that is fundamentally misaligned will eventually beattacked, and governments will be ill equipped to prevent it.Moreover, the longer adjustment is delayed, the higher the cost interms of resource misallocation. China is piling up billions ofdollars in foreign exchange reserves to defend its undervaluedcurrency, and wasting valuable capital that could earn a muchhigher return in the booming private sector or be used to helpprivatize SOEs or finance the transition to a fully funded pensionsystem.15

The argument that intervention is necessary to get all partiesto agree to let their currencies appreciate against the dollar inEast Asia is questionable. Stephen Green, senior economist atStandard Chartered Bank in Hong Kong, notes that it is unlikelythat Asian currencies would stand still while China let theRMB/dollar rate appreciate.16 Letting all Asian currencies increase at thesame rate against the dollar would not put anyone at a competitivedisadvantage for inter-regional trade. If a country did not followsuit, it may have a temporary advantage. But as its trade surplusgrew, there would be pressure to revalue or suffer inflation as ameans to revalue the real exchange rate. Changing one price-theexchange rate-is far less costly than changing the relative pricelevel.

Rather than a new Plaza-Louvre type agreement, an alternativeapproach to correcting global imbalances is to have monetaryauthorities agree on common principles and objectives. In a worldof pure fiat monies, the principle should be to establishcredibility by having central banks constrain themselves tolong-run price stability. Many central banks already have adoptedinflation targeting and have substantially reduced inflation.

vHans Genberg, executive director for research at the Hong KongMonetary Authority, has suggested creating a "zone of monetarystability" in East Asia. The key step would be to agree on acredible inflation target regime. To be consistent with capitalfreedom, central banks would not intervene to peg exchange rates.The information contained in flexible rates would be useful in theconduct of monetary policy, and some monetary authorities maychoose to follow the Singaporean model by using the exchange rateas an operating target. (Hong Kong would maintain its currencyboard and have a hard peg to the dollar.) With regional pricestability and financial integration, interest rates would convergeand exchange rates would be less volatile. Although a commoncurrency may evolve-either for the region or more likely for asmaller bloc of countries-it is not necessary to realize thesebenefits.17

China needs an independent central bank to stabilize the growthof nominal income and prevent inflation. Relaxing capital controlswould take pressure off the RMB/dollar exchange rate while interestrate liberalization would allow a more efficient allocation ofcapital. A more flexible exchange rate regime would allow the RMBto find its true value in the marketplace. The problem is to getChina to adopt liberal economic principles when its politicalregime is illiberal. For the United States to threaten China withprotectionist measures for not adopting liberal principles iscounterproductive. Carrying out the threat would make both Chinaand the United States less liberal.

A better tactic is for the United States to follow its ownliberal principles and put its house in order before telling otherswhat to do. After all, government profligacy is behind the U.S.fiscal deficits and low saving rate that mirror our persistentcurrent account deficits. We are fortunate America is still a havenfor foreign investors, but at some point accumulating furtherdollar-denominated assets may not be prudent for foreign centralbanks and private investors. Indeed, the growth of entitlementprograms could double the size of the federal government as apercent of GDP-from 20 percent to 40 percent-by 2075.18 The resulting deficits would beenormous and put significant upward pressure on interest rates,especially if foreigners failed to hold our debt. We do not need aninternational agreement to limit the size of our government; we cando it ourselves by sticking to the principles of economicliberalism.

China has expressed its long-run desire to make the RMB fullyconvertible, allow market forces to guide the exchange rate, and toliberalize interest rates. It is in China's self-interest to do so.Creating an international market-liberal order is a slow process,in which the United States must take a leadership role-not bydictating policy but by example and persuasion. Sound domesticmonetary policy, unilateral free trade, and limiting the size andscope of government are essential in this endeavor.

With stronger private property rights and long-run pricestability, China would attract and retain capital-including humancapital. People would be free to choose in international capitalmarkets and free to trade. A fully convertible RMB, a flexibleexchange rate, and a stable domestic price level would enhance botheconomic and personal freedom.

It makes no sense for a capital-poor country like China tosuppress market forces and to accumulate massive foreign exchangereserves, now approaching $1 trillion. According to Greenwood, "IfChina's capital markets and its industries were normalized (throughderegulation, proper implementation of the rule of law, theencouragement of private markets, and extensive private ownership),then China's balance of payments would no doubt undergo a majortransformation."19

The transition to capital freedom will be smoother, saysGreenwood, if the PBC pursues a policy of monetary stability-thatis, provides a framework for long-run price stability. To do so,however, requires that the PBC let market demand and supplydetermine the equilibrium value of the exchange rate and focusprimarily on controlling domestic money and credit growth, whichmeans interest rates must also be liberalized. On the other hand,"under a fixed nominal rate framework, external capital controlsare much more likely to be maintained and the adjustments to thetrade and current account are therefore much less likely tooccur."20

If Beijing chooses to keep the RMB/dollar rate undervalued andmaintains capital controls, China will continue to experiencestop-go monetary policy (see Figure 3) as the domestic money supplyresponds to the balance of payments and the PBC attempts tosterilize capital inflows.

Beijing needs to be more forthright in describing its financialand monetary system. The State Council announced earlier this yearthat it wants to achieve an external balance in 2006, but China'soverall trade surplus will match or exceed last year's historicalhigh of $102 billion. Likewise, the PBC constantly says its goal isto pursue a "sound monetary policy" and "keep the RMB exchange ratebasically stable at an adaptive and equilibrium level." Yet, moneyand credit continue to grow at rates inconsistent with long-runprice stability, and the exchange rate is still pegged at adisequilibrium level.

Media Name: 08222006-figure3.png

Source: UBS Asian Economic Monitor, "China bythe Numbers (July 2006)," p. 6.

The PBC recommends "better coordination among the various macropolicies, transformation of government functions, and institutionalinnovation." It also promises that the "foreign exchange systemreform will be deepened," including "facilitating trade andinvestment, promoting capital account convertibility, expandingchannels for capital outflow, fostering the growth of [the] foreignexchange market, [and] further improving the RMB exchange rateregime." Finally, the PBC has committed to "preserve the continuityand stability of monetary policy, and promote appropriate growth ofmoney and credit, in order to provide a stable monetary andfinancial environment for economic restructuring."21

Those objectives are laudable, but thus far the rhetoric hasfailed to match the reality. For example, in its "Monetary PolicyReport" for 2003, the PBC stated that it "continued to carry outsound monetary policy," even though broad money growth (M2) hadgrown on average by 20 percent that year. The report also said thatthe PBC would maintain the RMB exchange rate "at an adaptive andequilibrium level."22 Yet,the RMB/dollar rate remained fixed at 8.28 from 1994 until July 21,2005, when it was revalued by 2.1 percent, and has only appreciatedslightly since then to about 7.98 RMB/dollar. As a result, China'sforeign exchange reserves have more than doubled since 2003 (seeFigure 2). Clearly, financial repression is the hallmark of China'sstate-directed financial regime. The pace of reform will dependlargely on how much power the CCP is willing to give up in favor ofthe flexibility and liberalization needed for maintaining robusteconomic growth and stability.

The Politics of China's Economic Reform Movement

Since the start of the reform movement in late 1978, China'sleaders have declared that the CCP's top priority should be toachieve robust economic growth and improve the standard of living.They chose this path of "peaceful development" to minimize thelikelihood of civil and economic unrest that dominated the Maoregime. The failure of central planning and the Soviet developmentmodel led to institutional innovation and economic restructuring.China's accession to the World Trade Organization (WTO) in December2001 was further evidence of the commitment to liberalize trade andthe financial sector.

Progress has been made since 2001, but as the foregoing analysisimplies much remains to be done.23 There has been much discussion of how Chinashould sequence its economic reforms and make the transition fromfinancial repression to capital freedom. It is clear that openingcapital markets without reforming state-owned banks and withoutmaintaining monetary stability could lead to substantial capitalflight and exacerbate the problem of nonperforming loans. Moreover,there must be an effective legal system to protect newly acquiredprivate property rights.

In a recent interview, Zhou Xiaochuan, the head of the PBC,emphasized that China is committed to create an institutionalframework for a more flexible exchange rate regime "based on marketdemand and supply," and "gradually realize RMB convertibility . . .by lifting the restrictions on cross-border capital movements in aselective and step-by-step manner." In sequencing the financialsector reforms, the first priority is to put the banking system ona sound footing by recapitalizing the large state-owned banks andturning them into joint-stock companies with the participation offoreign strategic investors. Further progress must also be achievedin widening the scope of foreign exchange transactions, includingliberalizing the capital account. Zhou recognizes thatinstitutional change cannot occur overnight because "people needsome time to learn and adapt to change." A new "mindset" must bedeveloped. Moreover, he understands that China "cannot wait tostart reforming the exchange rate regime until all banking reformmeasures have been completed."24 Reform must move along a broad front.

Financial restructuring is occurring and the new exchange rateregime should allow for more flexibility, but one should not thinkthat the CCP would easily give up its control over the financialsector or allow the exchange rate to be set by market forces.Political change must accompany economic reform if capital freedomis to be fully realized.

Policy Recommendations

The United States and China need to continue the policy ofengagement and recognize that it is more important to focus on theissue of capital freedom than on the narrow question of the properexchange rate. China should continue to liberalize its exchangerate regime, open its capital markets, allow full convertibility ofthe RMB, liberalize interest rates, and use domestic monetarypolicy to achieve long-run price stability. Most important, Chinaneeds to privatize its stock markets, its banks, and its firms.

The need for reform of China's financial sector is widelyrecognized by Chinese officials and leading economists. Wang Zili,vice director of the Guangzhou Branch of the PBC has emphasized theneed for market-based interest rates that reflect the supply anddemand for funds. He argues that without liberalization, theinterest rate cannot effectively function as a tool of monetarypolicy: "A prerequisite for interest rates to take effect inmacro-regulation is that capital demand and supply should be highlymarket-oriented." Thus, "the most important thing for us to do isto form a reasonable interest rate structure."25 Recently banks have been given morediscretion in setting loan rates, but the PBC still relies onadministrative measures to curb excessive money and creditgrowth.

The PBC's Monetary Policy Committee has been concerned with thelack of flexibility in the current financial system and made thefollowing recommendations at its third quarterly meeting in2005:

  • "The market itself should be allowed to play its role ineconomic restructuring."
  • "Market-based interest rate reform policies should becontinuously carried out."
  • "Measures should be taken to further improve the managedfloating exchange rate regime and maintain the exchange rate…at an adaptive and equilibrium level."
  • "Efforts should be made to advance financial reform" and "toenhance the effectiveness of monetary policytransmission."26

Those pro-market policy recommendations are a positive sign anda clear signal that China's top policymakers are aware of whatneeds to be done to improve the financial architecture.

If China is to carry out its plans for financial liberalizationand have a flexible exchange rate regime, the PBC must have greaterindependence. Indeed, He Fan and Zhang Bin, economists with theChinese Academy of Social Sciences, have argued that Beijing "mustmake implementation of an independent monetary policy its toppriority."27 With greaterindependence will come greater transparency and credibility. Untilthat time, the PBC will be heavily politicized and its statementswill lack the credibility necessary to assure global investors thatstop-go monetary policy has ended.

In addition to internal pressures for financial reform, China isfacing external pressures from the U.S. Congress and the WTO forending exchange and capital controls. China has promised to allowfull participation by foreigners in its banking sector by 2007 andto further open to foreign portfolio investment. However, China isintent on moving at its own pace, especially regarding thetransition to a floating exchange rate regime. According to Zhou,the "noises" being made on Capitol Hill (e.g., by DemocraticSenator Charles Schumer and Republican Senator Lindsey Graham) forprotectionist measures-if China does not significantly revalue theRMB/dollar exchange rate-"will not change the basic conditions andsequence of China's exchange rate reform."28

Congress can best foster sound U.S.-China relations by nottreating China as an inevitable enemy and by taking the opportunityto capitalize on China's emergence as a market economy, albeit a"socialist market economy." In particular, U.S. policymakersshould

  • treat China as a normal rising power, not as a probableadversary;
  • continue to liberalize U.S.-China relations and hold China toits WTO commitments;
  • recognize that advancing economic freedom in China has hadpositive effects on civil society and personal freedom for theChinese people.29

Conclusion

President Hu Jintao's "big idea" is to create a "harmonious andprosperous society" via "peaceful development." To achieve thatgoal, however, requires institutional change-namely, a genuine ruleof law that protects persons and property. As Wu Jinglian, one ofChina's leading reformers, recently stated: "If we don't establish[a] fair rule of law and don't have clear protection of propertyrights, then this market economy will become chaotic and corruptand inefficient."30 It alsorequires "new thinking," so that people come to understand andappreciate how nonintervention (wu wei), in the sense oflimited government, is conducive to a spontaneous market order.

Long before Adam Smith, Lao Tzu argued that when the ruler takes"no action," "the people of themselves becomeprosperous."31 China'sleaders should turn to "Lao Tzu thought" if they want to realize a"harmonious and prosperous society." The success of the reformmovement-and China's growing middle class-has come from increasedeconomic freedom, not from top-down planning. Trade liberalizationand the growth of the nonstate sector have been the hallmarks ofChina's new economy. It is now time to get rid of the last legacyof central planning-state-directed investment and capital/exchangecontrols-and end financial repression.

Congress would be wise to focus on capital freedom rather thanbash China for its large trade surplus with the United States, andblame that imbalance on an undervalued RMB/dollar exchangerate.32 Protectionistmeasures to force China to revalue would place a large tax on U.S.consumers and not advance capital freedom.33 Adherence to the principles of a liberalinternational order-as opposed to muddling that policy conceptionby threatening to adopt protectionist measures intended to forceinternational agreements that may distort the international pricesystem-should be the primary object of U.S. policy.34

For its part, China needs to follow the Tao of the market if itis to fulfill the promise of "peaceful development." Endingfinancial repression by liberalization, privatization, andcompetition would increase the chances for political reform. TheUnited States and other free countries can help China move in theright direction by adhering to a policy of engagement rather thanreverting to destructive protectionism.

We do not want to repeat the mistakes of the 1930s, when theSmoot-Hawley tariff and monetary policy errors effectively endedthe liberal international order.35 Free trade and financial integration areessential for prosperity and peace. As Cordell Hull, U.S. secretaryof state from 1933 to 1944, wrote, "Unhampered trade dovetailedwith peace; high tariffs, trade barriers, and unfair economiccompetition with war."36


1 For a discussion of thenew Bretton Woods system, see Michael P. Dooley, DavidFolkerts-Landau, and Peter Garber, "An Essay on the Revived BrettonWoods System," NBER Working Paper, no. 9971, September 2003.
2 See John Greenwood, "TheReal Issues in Asia," Cato Journal 20, no. 2 (Fall 2000):141-57.
3 See Anna J. Schwartz, "DoWe Need a New Bretton Woods?" Cato Journal 20, no. 1(Spring/Summer 2000): 21-25.
4 See John B. Taylor, "WhatComes after 'Bretton Woods II'?" Wall Street Journal,August 15, 2005, p. A12.
5According to a recent studyby Dan Ikenson, a trade policy analyst at the Cato Institute,"currency values have had little to do with changes in the tradebalance in recent years." See "Currency Controversy: Surplus ofPolitics, Deficit of Leadership," Center for Trade Policy Studies,Free Trade Bulletin, no. 21, May 31, 2006, p. 1
6 See Alan Greenspan, "TheEvolving U.S. Payments Imbalance and Its Impact on Europe and theRest of the World," Cato Journal 24, nos. 1-2(Spring/Summer 2004): 1-11.
7 Wanfeng Zhou, "Dollar Up asU.S. Data Exceed View: China Looks to Diversify Reserves, IgnitingU.S. Deficit Concern," MarketWatch(www.marketwatch.com/News), July 25, 2006.
8 On recent reforms, see FredHu, "Capital Flows, Overheating, and the Nominal Exchange RateRegime in China," Cato Journal 25, no. 2 (Spring/Summer2005): 357-66, and Stephen Green, "China: Interest Rates, QDII, andLiquidity Challenge," On the Ground-Asia, Standard CharterBank, Hong Kong, April 17, 2006. Green calls the April 13, 2006liberalization of controls on capital outflows for qualified banks,mutual funds, and insurance companies "revolutionary." The changeis an important signal for reform, but the measures still need tobe implemented and the sums involved will be small.
9 The UBS capitalrestrictiveness index is based on a score of 10 (closed capitalaccount) to 1 (open capital account). In calculating this index,UBS takes account of "the number of legal impediments to capitalaccount transactions" and "the size and variability of actual expost capital flows." Jonathan Anderson, "How to Think About China(Part 6): Seven Ways China Won't Change the World," UBS AsianEconomic Perspectives, November 28, 2005, p. 23, n. 3.
10 On the difficulty ofpreventing "hot capital" from entering China, see Green, "HotMoney: If Only We Knew How Much," On the Ground-Asia,Standard Chartered Bank, Hong Kong, August 3, 2006.
11 See William R. Cline,"The Case for a New Plaza Agreement," Policy Briefs inInternational Economics, no. PB05-4, December 2005,Washington, D.C., Institute for International Economics.
12 For a fuller treatmentof the Plaza and Louvre agreements and the mistakes in Japanesemonetary policy, see David F. DeRosa, In Defense of FreeCapital Markets: The Case against a New International FinancialArchitecture (Princeton, N.J.: Bloomberg Press, 2001), pp. 8.,36-54, 199.
13 Greenwood, "The RealIssues in Asia," p. 146.
14 Cline, p. 9
15 On how reserves could beused to help China make the transition to economic liberalism, seeDeepak Lal, "A Proposal to Privatize Chinese Enterprises and EndFinancial Repression," Cato Journal 26, no. 2(Spring/Summer 2006): 275-86.
16 Green, "CNY AppreciationWill Increase China's Surplus," On the Ground-Asia,Standard Chartered Bank, Hong Kong, August 1, 2006, p. 2.
17 Hans Genberg,"Exchange-Rate Arrangements and Financial Integration in East Asia:On a Collision Course?" Bank of Greece Working Paper, no. 41, May2006, p. 17. Adopting a single currency for Asia is neithereconomically nor politically feasible at this time or in theforeseeable future. Economic conditions and political environmentsare too diverse to warrant a currency union. See Jonathan Anderson,"Still Not a Great Idea," UBS Asian Focus, May 12,2006.
18 "A 125-Year Picture ofthe Federal Government's Share of the Economy, 1950 to 2075,"CBO Long-Range Fiscal Policy Brief, no. 1, July 3, 2002,Washington, D.C., Congressional Budget Office,http://ftp.cbo.gov/showdoc.cfm?index=3521&sequence=0.
19 John Greenwood, "TheImpact of China's WTO Accession on Capital Freedom," CatoJournal 21, no. 1 (Spring/Summer 2001): 93.
20 Ibid., pp. 93-94.
21 "An Interview with thePBC Spokesperson on Current Issues," May 23, 2006,www.pbc.gov.cn/english//detail.asp?col=6400&ID=684.
22 "China Monetary PolicyReport, 2003," the People's Bank of China, Executive Summary, March17, 2004,www.pbc.gov.cn/english//detail.asp?col=6613&ID=31.
23 For a summary of China'ssteps toward financial sector liberalization since December 2001,see Su Ning, deputy governor of the PBC, "Press Ahead with Reformand Opening-Up and Promote the Rapid and Healthy Development of theFinancial Sector," July 10, 2006,www.pbc.gov.cn/english/detail.asp?col=6500&id=121.
24 "Governor Zhou XiaochuanSpeaks on Issues Related to the Reform of the Exchange RateRegime," People's Bank of China News, September 10, 2005, pp. 1-2,13. Available at www.pbc.gov.cn/english//detail.asp?col=6400&id=572.
25 "Reasonable InterestRate Structure Urged," China Economic Net, September 22,2004,http://en.ce.cn/Business/Macro-economic/200409/20/t20040920_1804840.sht….
26 "Monetary PolicyCommittee of the PBC Held the 3rd Quarterly Meeting of 2005,"People's Bank of China News, September 26, 2005. Available atwww.pbc.gov.cn/english//detail.asp?col=6400&id=593.
27 He Fan and Zhang Bin,"No Haste in Forex Reform," China Business Weekly,February 9-15, 2004, p. 21.
28 "Governor ZhouXiaochuan," p.3.
29 For an expansion ofthese policy recommendations, see Ted Galen Carpenter and James A.Dorn, "Relations with China," in Cato Handbook on Policy,6th ed. (Washington, D.C.: Cato Institute, 2005), chap. 61.
30 Wu Jinglian quoted in"Official Urges Rule of Law in China," International HeraldTribute, March 6, 2006.
31 See James A. Dorn,"China's Future: Market Socialism or Market Taoism?" in Chinain The New Millennium, ed. James A. Dorn (Washington: CatoInstitute, 1998), pp. 104-6.
32 Stephen Green arguesthat China's large processing trade means an appreciation of theRMB/dollar rate could increase China's trade surplus or at leastnot substantially decrease it. See Green, "CNY Appreciation."
33 See Daniel Griswold,"Who's Manipulating Whom? China's Currency and the U.S. Economy,"Trade Briefing Paper, no. 23, July 11, 2006 (Washington, D.C.: CatoInstitute, Center for Trade Policy), pp. 10-11.
34 On the shortcomings ofthe negotiations approach to a liberal international order and thebenefits of a principled approach, see Jan Tumlir, "Economic Policyfor a Stable World Order," in Dollars, Deficits, andTrade, ed. James A. Dorn and William A. Niskanen (Boston:Kluwer, 1989), chap. 18. Also see Roland Vaubel, "A Public ChoiceApproach to International Organization," Public Choice 51(1986): 39-57, and Deepak Lal, Reviving the Invisible Hand: TheCase for Classical Liberalism in the Twenty-First Century(Princeton, N.J.: Princeton University Press, 2006).
35 On the Smoot-Hawleytariff and the end of the "liberal international economic order,"see Lal, p. 39.
36 Cordell Hull, TheMemoirs of Cordell Hull, vol. 1 (New York: Macmillan, 1948),p. 81.

James A. Dorn

U.S.-China Economic and Security Review Commission
109th Congress: Second Session