China's Exchange Rate and Monetary Policies: Structural and Institutional Constraints and Reform Options

This paper argues that declining transaction costs in exporting on the one hand and the structural and institutional barriers to importing and consumption on the other hand are the main causes for China's rising current account surplus. Reforms in China's planning, financial, and regulatory systems are more important than adjustment in nominal exchange rate for balancing China's trade and for China's surplus capital to hire more of its surplus labor. Although structural inflation and currency appreciation are necessary for China's price level to catch up step-by-step with those in the advanced economies, the pace of inflation and appreciation need to be compatible with China's underlying productivity growth. An "inflation first and appreciation second" approach would help China avoid the risks of both deflation and runaway inflation. The United States and China can have win-win results if both focus on the real constraints behind their external imbalances. (c) 2008 The Earth Institute at Columbia University and the Massachusetts Institute of Technology.