Business Insider

Peter Crabb: China should stop tying its currency to the dollar; Idaho could benefit

Tying your fate to a sinking ship can be deadly. China, which has been hooked on our rudder for a long time, would help us both if it took a lesson from Eastern Europe.

Visiting China this week, U.S. Commerce Secretary Gary Locke said the country should allow greater flexibility in its exchange rate and open local markets for more imports and foreign direct investment. Locke said such a move “would accelerate the world's return to growth.”

Locke went further to say that current imbalance in U.S.-China trade is at least partially due to the fixed exchange rate and a partial cause of the current economic crisis. The fixed yuan/dollar rate keeps U.S. imports from China too high and requires China to hold too many dollar reserves.

A fixed-exchange rate regime occurs when a government or central bank ties the value of its currency to that of another country’s currency or a commodity like gold. The primary benefit of such a system is greater certainty for exporters and importers. China has long benefited from large exports to the U.S.

China’s system uses what is a called a "central parity rate" for the yuan. The yuan is allowed to move no more than 0.5 percent against the dollar on any given day. This week the parity rate was set at 6.8310 yuan to a dollar.

Fixed regimes like this can increase the severity of any economic or financial crisis. The parity rate will be difficult to maintain in the long run.

China’s crisis today is a larger need to stimulate local economic activity that disappeared with the slowing U.S. economy. China’s government stimulus package at $586 billion is smaller than the $787 billion U.S. plan, but as a percent of GDP, China is spending 17 percent of income compared with our 5 percent.

Meanwhile, many Eastern European countries are finding comfort and opportunity from their policies of freely floating exchange rates. According to a recent report in the Financial Times, those countries that pegged their currency rate to the euro may even avoid a recession this year. The governments of Latvia, Lithuania and Estonia maintain fixed rates and are currently experiencing the deepest recessions among member countries in the European Union. Slovakia actually adopted the euro earlier this year, so economic activity contracted at an annualized rate of 11.4 percent in the first quarter.

The Czech Republic meanwhile saw the value of its currency, the koruna, fall against the euro during this crisis, and its economy has contracted by only 3.4 percent. Similarly, the currency of Poland, the zloty, rose from 3.2 to 4.3 against the euro since last year and the country is likely to finish 2009 without a recession.

A floating exchange rate could help Idaho. According to the Idaho Department of Commerce, China is Idaho’s third-largest export destination. However, Idaho exports to China during 2008 declined by more than 36 percent. With a floating exchange rate, exports would likely have stayed the same, or even increased, as the yuan rose in value against the dollar.

Floating exchanges rates provide a country more flexibly in times of financial crises or economic shocks. Without a widely traded and freely adjusting dollar, the U.S. Federal Reserve and federal government would have had nothing to work with.

China is paying a price for fixing the yuan to the dollar. Calls by China’s government for a new world reserve currency can be characterized as a simply a call for help.

China no longer wants to sail with us.

Since 2000, Peter R. Crabb has been a professor of finance and economics at Northwest Nazarene University in Nampa. He earned his doctorate in international and financial economics from the University of Oregon.