Remember China's undervalued exchange rate? A year ago, virtually every investment-bank economist said China was on the verge either of revaluing to a rate of around seven yuan to the US dollar, or widening the trading band to allow the value of the currency to fluctuate.
As we said at the time, these arguments ignored both history and economic fundamentals. The history was that in 1998, after the Asian financial crisis, China faced enormous pressure to devalue its currency. Officials trooped out from Washington virtually begging Beijing to hold firm. For its own reasons, Beijing did hold firm. It earned a big dividend: international respect as a 'responsible' player in the global economy, and renewed confidence from foreign investors.
Having experienced the benefits of riding out the devaluation wave in 1998, Beijing had strong cause to ride out the revaluation wave - all the more so since having an undervalued currency is far less dangerous than having an overvalued one.
Nonetheless, Beijing has repeatedly affirmed its commitment in principle to a more flexible exchange-rate regime. This is what gives rise, every so often, to misguided speculation that it is about to widen the yuan trading band - a move which, in the absence of other policy measures, is about the most stupid thing Beijing could do. Understanding how China will change its exchange-rate regime is really a matter of understanding two simple points.
First, an undervalued exchange rate is far less dangerous than an overvalued one. Early in their development cycles, Japan, Singapore and Taiwan all had fixed, undervalued currencies and then allowed them to appreciate gradually. All enjoyed stable, crisis-free growth. By contrast, the Asian crisis countries - notably Thailand, South Korea and Indonesia - all had fixed overvalued currencies. All suffered overnight devaluations which caused immense economic shock.
The reason is straightforward. An undervalued currency encourages countries to earn foreign exchange through exports, and exporters can adjust to a gradually rising exchange rate by gradually moving up the value chain. An overvalued currency encourages governments and companies to finance growth not through exports, but by borrowing too much cheap foreign exchange. Any depreciation threatens their position, so countries get locked into defending the overvalued currency for too long. When the crash comes, it is a big one.
