The economics behind China's exchange rate crisis

Jeffrey Frankel, a professor of economics at Harvard University, believes the laws of economics Will eventually force the Yuan to rise against the dollar, in real terms at least. China's economy is growing exponentially, and the Chinese government seems either unwilling or unable to cool it off. As the demand for Chinese goods continues to skyrocket, so too must prices. According to Frankel, the extent of the rise will be such that in a decade, the Chinese Yuan will be fairly valued against the USD, in real terms. While nominally, one USD would be worth 8.28 Yuan, the inflated costs of Chinese goods would ensure equilibrium. Such a situation would be disastrous for China, however. It would be in China's best interest to slowly appreciate the Yuan against the Dollar, through the use of a crawling peg exchange rate regime. If China waits to long, warns Frankel, the results could be catastrophic. Reuters reports:

"The alternative of waiting for a time of balance-of-payments deficit often turns out to mean exiting the peg under strong downward speculative pressure, with the result that confidence is undermined and the national balance sheet is weak," Frankel says.

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