China's Current Account Surplus and the Yuan

"If you think U.S. President George W. Bush's administration had a tough time dealing with China, the next occupant of the White House may have it worse." So claims yesterday's International Herald Tribune.

The article offers a clear explanation for the mechanism through which pegging the yuan to the dollar reinforces the savings - investment gap that underlies China's current account surplus.

It also hints at the dilemma the Chinese monetary authorities now face. Pegging the yuan requires continual purchases of foreign assets, which in turn expands the money supply, which in turn generates inflation. Stemming inflation requires higher interest rates, which may well pull in additional capital flows, thereby forcing the central bank to accumulate still more foreign exchange reserves, additional monetary expansion, and more inflation. In short, the desire to keep domestic prices stable is not easily reconciled with the desire to maintain the pegged exchange rate.

One obvious solution to this dilemma is to allow the yuan to float. No sign that this is likely to happen any time soon.