US Federal Reserve Chairman Ben Bernanke offered the Chinese good advice in a speech he recently gave in Beijing as part of the newly instituted strategic discussions between the United States and China. Unfortunately, he also offered some very bad advice in assessing the ramifications and risks of Chinese currency policy.

In essence, the Bernanke critique was a one-sided interpretation of a key issue that could backfire and lead to a worrisome deterioration in the economic relationship between the United States and China.

The offensive passage in the written version of the Bernanke speech posted on the Fed's website was the assertion the current value of the Chinese renminbi is an "... effective subsidy that an undervalued currency provides for Chinese firms that focus on exporting rather than producing for the domestic market."

The use of the word "subsidy" is a highly inflammatory accusation in effect, putting the Chinese on notice that America's most important macro policy maker believes RMB currency policy provides the Chinese with an unfair advantage in the world trade arena that fosters distortions in China's economy, the US economy, and the broader global economy.

In my view, this is a very biased assessment of the state of Chinese currency policy and reforms. It pays little attention to the context in which RMB policies are being formulated and, ironically, fails to provide any appreciation for the benefits that accrue to America as a result of this so-called subsidy.

Moreover, Bernanke's spin continues to downplay the role the United States is playing in creating its bilateral imbalance with China to say nothing of the role the United States is playing in fostering broader imbalances in the global economy.

The real question in all this is, who's subsidizing whom? Conveniently overlooked in the Bernanke critique is an important flip side to the "managed float" that continues to drive RMB policy China's massive purchases of dollar-denominated assets.

The exact numbers are closely held, but there is close agreement that between 60-70 percent of China's US$1 trillion in official foreign exchange reserves are split between some US$345 billion invested in US treasuries (as of October 2006, according to the US Government's TIC reporting system) and a comparable amount held in the form of other dollar-based fixed income instruments.

With Chinese reserve accumulation now running at more than US$200 billion each year, the above mentioned estimates imply new purchases of at least US$120 billion per year of dollar-denominated assets.

Such foreign demand for US financial assets is absolutely critical in plugging the funding gap brought about by an unprecedented shortfall of domestic US saving a net national saving rate that fell to a record low of just 0.1 percent of national income in 2005.

Without China's purchases of dollar-based assets a key element of its efforts to mange the RMB in accordance with its financial stability objectives the dollar would undoubtedly be lower and US interest rates would be higher.

In effect, that means China is subsidizing US interest rates providing American borrowers and investors with cut-rate financing and rich valuations that otherwise would not exist were it not for the dollar recycling aspects of Chinese currency policy.

There is an added element of China's subsidy to the United States. As a low-cost and increasingly high-quality producer, China is, in effect, also providing a subsidy to the purchasing power of US households.

Close down trade with China as many in the US Congress wish to do and the deficit would show up somewhere else, undoubtedly with a higher-cost producer. That would be the functional equivalent of a tax hike on the American consumer cutting into the subsidy the United States currently enjoys by trading with China.

The Fed Chairman is making a similar suggestion: By allowing the RMB to strengthen, China's dollar buying would diminish effectively eroding the interest rate and purchasing power subsidies that a short saving and increasingly asset-dependent US economy has come to rely on.

We can debate endlessly the appropriate valuation of the Chinese currency. Economic theory strongly suggests that economies with large current account surpluses typically have under-valued currencies.

China would obviously qualify in that regard as would, of course, Japan, Germany, and many Middle East oil producers.

The fact that China is being singled out for special attention is, in and of itself, an interesting comment on the biases in the international community.

Nevertheless, it is quite clear that China understands this aspect of the problem.

By shifting to a new currency regime 17 months ago, Chinese policy makers explicitly acknowledged the need for more of a market-based foreign exchange mechanism.

The RMB has since risen about 6 percent against the dollar not nearly as much as many US politicians are clamoring for, but at least a move in the right direction.

Risk-averse Chinese policy makers feel strongly about managing any currency appreciation carefully understandable, in my view, given the still relatively undeveloped state of China's highly-fragmented banking system and capital markets.

The potential currency volatility that a fully flexible foreign exchange mechanism might produce could have a very destabilizing impact on an undeveloped Chinese financial system. And that's the very last thing China wants or needs.

Bernanke's criticism of the Chinese for subsidizing their export competitiveness by maintaining an undervalued RMB completely ignores the benefits being enjoyed in the United States through equally important subsidies to domestic interest rates and purchasing power.
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Bernanke failed to acknowledge the extraordinary fragmentation of a highly regionalized Chinese banking system dominated by four large banks that still have well over 60,000 autonomous branches between them.

How a central bank gets policy traction with such a decentralized banking system is beyond me. Moreover, he basically overlooks another critical reason for China's irrational investment process the lack of well-developed capital markets and the continued reliance on policy-directed lending by China's large banks.

Instead, Bernanke suggests that a flexible currency is the best means to foster an efficient allocation of investment projects.

In short, the flaw in the Bernanke critique is his failure to appreciate the very special transitional needs of a still blended Chinese economy currently straddling both State and private ownership systems, as well as centrally-planned and market-directed allocation mechanisms.

There are some interesting footnotes to the Bernanke speech. Significantly, the Fed Chairman actually flinched when it came to the oral version of his speech offering a last-minute substitution of the word "distortion" for "subsidy."

(China Daily December 25, 2006)