Abstract

Fixed and flexible exchange rates each have advantages, and a country has the right to choose the regime suited to its circumstances. Nevertheless, several arguments support the view that China should allow its currency to appreciate. (1) China’s economy in 2004 was on the overheating side of internal balance, and appreciation would help easy inflationary pressure. Although this excess demand probably moderated in 2005, the general principle remains: to achieve both internal balance and external balance simultaneously, an economy needs to be able to adjust its real exchange rate as well as its level of spending. (2) Although foreign exchange reserves are a useful shield against currency crises, by now China’s current level is fully adequate, and US treasury securities do not pay a high return. (3) It becomes increasingly difficult to sterilize the inflow over time. (4) Although external balance could be achieved by increasing expenditure, this policy applied by itself might send China back into the inflationary zone of excess demand. (5) A large economy like China can achieve adjustment in the real exchange rate via flexibility in the nominal exchange rate more easily than via price flexibility. (6) The experience of other emerging markets points toward exiting from a peg when times

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