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Feb. 19: China Should Adopt More Flexible Exchange Rate For Its Own Good, Says Carnegie Mellon Economist

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Geof Becker                        
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gbecker@andrew.cmu.edu

China Should Adopt More Flexible Exchange Rate
For Its Own Good, Says Carnegie Mellon Economist

Commentary in Foreign Policy Argues Market-Driven Currency Necessary To Enable Economic Reform, Manage Growth and Boost Domestic Consumption

PITTSBURGH — China is under increasing pressure from U.S. politicians to adopt a more market-driven currency rate to level the economic playing field internationally. However, according to a leading international economist from the Tepper School of Business at Carnegie Mellon University, an even more compelling reason for Chinese officials to pursue exchange rate reform is that it's a necessary and beneficial next step in their nation's economic development.

GoodfriendIn the January/February edition of Foreign Policy, Professor Marvin Goodfriend co-writes that adopting an independent interest rate policy focused on keeping inflation low and stable would provide greater overall benefit to Chinese citizens and allow the Chinese government to more effectively pursue many of the economic reforms already under way.

The commentary, titled "China's Currency Crunch," was written by Goodfriend, professor of economics at the Tepper School, and Eswar Prasad, senior professor of trade policy at Cornell University. Goodfriend is the former senior vice president, policy advisor and research director at the Federal Reserve Bank of Richmond.

According to Goodfriend, the Chinese preoccupation with completing their country's dramatic transformation from an agricultural backwater to industrial powerhouse has seemed to preclude letting China's currency appreciate even modestly. "But the ultimate goal...is for its citizens to eventually enjoy the same kind of spending power that people in richer countries like the United States enjoy today. This is more likely to be attained by adopting a more flexible exchange rate policy in pursuit of their transition to a truly market-based economy."

Goodfriend notes that China's astonishing growth - now more than 11 percent a year - has "been largely fueled by domestic investment and exports, while domestic consumption remains relatively stagnant." While most countries would envy such a surge of money, it has made capital very cheap and allowed tremendous sums to flow "into real estate and equity markets, raising the risk of asset price bubbles that could easily burst," he said.

A focus on low inflation would, in contrast, make the Chinese economy "less likely to lurch forward recklessly, stumble and fall," and create a healthier environment where people, companies and governments are able to make sounder savings and investment decisions based on greater certainty about prices without ignoring other economic goals, such as high and stable growth.

Exchange rate flexibility would also encourage China's state-owned banks to operate like "modern financial institutions that respond to interest rates...carefully assessing and pricing risk," and "become robust and efficient financial intermediaries that could in turn aid in the transformation of the economy by financing the more dynamic private sector."

In addition, Goodfriend postulates that allowing exchange rate appreciation would boost China's domestic consumption in a country of diligent savers. "If Chinese households could get more dollars for their yuan, their purchasing power would go up and they would spend more, not only on items made at home but on global goods as well," he said.

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