Should China Float Its Currency?

October 15, 2003

Unedited transcript prepared from a tape recording

2:15 p.m.	Registration
2:30	Speakers:	Harvey Z. Chen, Shanghai Jiao Tong University
		Yusuke Horiguchi, Institute of International Finance
		Nicholas Lardy, Institute for International Economics
		John H. Makin, AEI
		Randal Quarles, U.S. Department of the Treasury
	Moderator:	Desmond Lachman, AEI
4:30	Closing Remarks:	Allan H. Meltzer, AEI
4:45	Adjournment

Proceedings:

MR. LACHMAN: --policy. The discussion promises to be very interesting and very informative because we have assembled a panel of people who've got real expertise on the Chinese economy and who are going to be giving us their different viewpoints on an issue that is, clearly, very important.

Before I begin, I really would like to thank the panelists for taking time out of their busy schedules to share their thinking with us. And I particularly want to thank Harvey Chen, who has made a trip from China to be with us this afternoon and to give us a Chinese perspective on the issues.

The issue of whether China should change its exchange rate regime, raises very many questions. There's the question, of course, of whether the Chinese currency is, indeed, undervalued and, if so, by how much is it undervalued? Is it in China's interest to change the exchange rate regime? If it does change the exchange rate regime, how fast should it do it? Should it float the currency? Should it move the peg in one shot? Should it introduce a ban? What should China do about its banking system and state enterprises which might be impacted by currency moves? And should China be forced to open up its capital accounts so to do more in terms of trade policy, you know, within the policy of WTO? These are very many questions that one could ask.

As Moderator, I don't feel it's my place to express views on these questions. It's not that I don't have views on the matter, but I think that's--with the experts around the table, it would be presumptuous of me to express views on those issues.

What I do want to do, though, is: I just want to make three points which, hopefully, will set the discussion in a broader frame work--in an international frame work--looking at a different perspective.

The first issue is: There's this whole question about what China's exchange rate policy should be is occurring at an interesting time in terms of exchange markets. In particular, while it appears that we're seeing is we're seeing a major adjustment in the U.S. exchange rates that's in response to what appears to be a very large imbalances in the international financial system, right now. Indeed, over the last few days what we've seen is, we've seen the dollar plummet to a three-year low against the Japanese Yen. And more markedly, we've seen the Euro practically at its strongest level in its four-year existence.

Given the size of the U.S. current account deficit, it would appear that we're only half way through the process. What this means for China, of course is that China being pegged to the dollar, will continue to gain in competitiveness against currencies against which the U.S. dollar is depreciating. And what I think that means is that Europe and Japan will soon be joining the chorus, perhaps a little bit more vociferously to get something done about the Chinese situation. It's certainly an issue that I don't see going away anytime soon. And I think that is an issue that's likely to intensify.

The second point that I'd like to make, I guess, is the obvious point that China is not alone in intervening in its currency market to keep the value of the Chinese Renminbi artificially low. If we look at Asia, Japan does this, Taiwan, Korea, Indonesia, Singapore, Malaysia, I limit myself to those countries because my sense of geography is not as strong as it should be. But basically what it means is we've got a group of countries that molds their exchange rate policy according to what China is doing. And if China were to change its exchange rate, there we be ramifications through the region.

So, we're not talking about simply about China. I think that we're talking about an issue that is very much broader, very much bigger than China.

The last point that I'd like to make is a point that the question of what China does to its exchange rate would seem to have bearing on what happens in international financial markets. And I'm thinking, in particular, in the U.S. financial market. And I don't know that one can talk about changes in Chinese exchange-rate policy without looking at what happens, for instance, in the United Sates bond market.

And this is particularly so, given the large budget deficit that the U.S. is running seems to be a deficit of the order of something like $500 billion. Now, in a world in which China were to float its currency, it's questionable whether China would need the approximately $350 billion that it's got in its national reserves, a large part of that is invested in U.S. Treasuries. And certainly China wouldn't need to accumulate additional reserves.

Why this is important is that China is estimated right now to be purchasing roughly 12 percent of U.S. issues. And if we broaden this to look at what would happen in the rest of Asia that wouldn't have to accumulate reserves, this could be a real issue. So, I would put that on the table.

With those opening remarks, I'd like to turn to our panel to begin our discussion. And what I've asked each of the panelists to do, is to talk for 10 or 15 minutes, give their perspective. We will then open it up to questions and then I'll have professor Allan Meltzer make concluding remarks, try to draw everything together.

So, how we'll proceed is, we'll start with Randy Quarles, who's the Assistant Secretary for International Affairs at the United States Treasury, who is intimately involved with the China question from the Treasury's point of view.

Having been to China recently, we'll follow Randy Quarles with Nick Lardy, who's a renowned expert on China; a scholar of distinction at the Institute for International Economics.

Following him, we'll turn to Yusuke Horiguchi, who presently is the First Deputy Manager Director at the Institute of International Finance and who was formerly Director of the IMF's Asian Department.

John Makin, who, I'm sure is well known to most of you hear, a colleague of mine at the AEI, will speak next.

And then, Harvey Chen, who is Chairman of the First Light Academy, an institution of leading academics and governmental experts from around the world, with interests in China, will speak last.

So, I'll call on Randy Quarles to speak. And I've asked him to speak from where he's sitting.

MR. QUARLES: Thank you. Thanks, Desmond. I will--I'll keep my remarks brief because I think that the greatest benefit from this sort of a gathering is the exchange that comes afterwards.

What I want to do is start out by placing the question that's on the table in front of us in the larger context in which we look at it at Treasury. Nothing particularly novel here, but I think it's useful in looking at this to step back for a moment.

The overall strategy, international economic strategy, of the Treasury in this Administration has been promoting economic growth and enhancing stability. You'd say it's a two-pronged approach. But of those two, if you were to say one of them had pride of place it's promoting economic growth. Whether that's the U.S.'s role in the international economy, the jobs and growth package and its importance in promoting growth in the United States; whether it's our approach to the developing world; they are not focusing as much on questions of official development assistance or debt relief, but saying that, while these have their role, the most central element is growth-promoting policies in these countries.

In the emerging markets, again, not focusing on financial engineering or iffy resources, but growth-promoting policies in these countries and how our own engagement with them can encourage them to adopt growth-promoting policies.

And then, finally, in the industrialized world, the theme that, again, we have been striking for some time that the U.S. can't be the sole engine of growth--Japan and the European Union need to make some necessary reforms in order to start growing again.

In fact, I would think that that is really the central message of the recent G-7 statement that people have focused on other aspects of it. But the--this increasing centrality of the pro-growth focus of the G-7, in their engagement with each other and with the rest of the world, is something that is a result of, again, this Administration's and this Treasury's focus on that question.

So, it's through this comprehensive lens of an overall focus on growth that we look at the question of China. And there, it's clear that the integration of China into the global economy, into the international trading system over the next several years is going to have enormous implications for this question of global growth; growth in China; growth in the world, generally; and growth in the United States. All of which are central questions for the Treasury.

And how the Chinese and how the international community manage this integration, therefore, obviously, has huge implications for future growth in all of these areas.

There are, I mean, there are estimates that I think a lot of people use that show that world trade could be, by the end of this decade, nearly 3 percent higher as a result of the Chinese WTO accession. That, as a consequence of increasing trade, world output could be close to 2 percent higher. A lot of that would be focused in Asia. There would be effects even in the United States. And in Europe, I think those estimates show that the U.S. would be not quite a percent higher and Europe a little over a percent higher.

And, therefore, in all of these areas where I was just talking about, the importance of increasing growth in the industrialized world--in the emerging markets in the developing world, China is a key element of that.

So, as we at the Treasury look at how we should be approaching our engagement on economic issues with China, there are a few obvious things that we ought to be pushing with them: One, we should pursue policies that support and promote China's domestic economic reforms. Increasing the efficiency of their companies and the financial sector which will allow China to effectively play its part in this growth-enhancing contribution that we've just been talking about.

Second, because of the importance of China's integration into the trading system, China--we should insist that China follow through on implementing and even surpassing it's WTO commitments. I think tariffs on manufactured goods are scheduled to come own from about 17 percent to about 9 percent. On average, that's still well above the average of the U.S. and other large economies, which I think is about 4 percent. So it would be in China's interest, as well as in the world economy's interest for China to even surpass its minimum WTO commitments.

It should open it's markets to agricultural products, like soybeans. It should take action on the intellectual property issues that we have with China.

And all of this will enhance China's ability to play a constructive role in the increase in output and growth in the world generally.

I begin with--and then we return to exchange rates, which clearly have a role. But I wanted to begin by setting it in context. Because while this is an important issue, and I just want to be sure that the fact that it has taken so much of the public space with respect to economic discussions about China, recently--and for good reason--doesn't, you know, doesn't--there seems to be a general sense developing that the currency issue, actually, is the fulcrum of our engagement with China as opposed to an element of our engagement with China.

And I think that looking overall at how we ought to be approaching our relationship with China shows that while this is an important element, it is one. And one that should be kept in perspective.

Now, having said that, then, let me just begin by noting what I think everybody in this room is reasonably aware of or else they wouldn't be in the room--that for a decade China has pegged its currency to the dollar, just a little under 8.3. To maintain that peg, they've had to intervene massively in the foreign exchange market. They've increased, over the last couple of years, their foreign exchange reserves by almost $153 billion, which brings them up to a little under 400.

This accumulation of reserves would tend to expand their money supply. In recent months, the Chinese Central Bank has moved somewhat to reign in the monetary expansion, but the broader money supply continues to grow very rapidly. M2 climbed 22 percent in the year that ended in August of this year.

Ultimately, obviously, if that isn't managed well, that can threaten price stability. And, given that loan growth in China is still dominated by the state-owned banks with their--with the credit culture that is endemic to state-owned banks everywhere, that can undermine--that sort of inflation could undermine the progress that's been made in reforming the banking system.

China's capital controls are also a rigidity in their system. They allow for more inflows than outflows. And, thus, that further bolsters foreign exchange reserves. They're gradually loosening some of these controls, as most of you may know. Outflows are, therefore, likely to grow as new channels will develop for the Chinese to seek diversification, better returns, you know, the markets. There already is a significant amount of leakage of capital. But the Chinese are officially doing some loosening that will allow for further leakage.

What's the impact of this situation on the United States and on the world generally?

Overall, U.S. imports from China right now are not large. Maybe about 1 percent of our GDP; 11 percent of our total imports. But that is increasing rapidly, as the estimates that I was citing earlier would indicate. About 20 to 25 percent annually is the rate of increase in the ratio of Chinese imports to our GDP and to our overall imports.

The growth of our exports to China has also been accelerating. They grew 22 percent in the first seven months of this year, especially rapid in U.S. exports of transportation equipment, like the aircraft engines, machinery, steel-making materials, chemicals, semiconductors.

China does have a large trade surplus with the United States. But because it has a large trade deficit with the rest of the world--it's actual overall trade balance is--it's overall current account surplus is not large. It's bilateral trade surplus with the United States was about a little over $100 billion in 2002. It's deficit with the rest of the world was about $75 billion.

It's current account surplus was under 3 percent of its GDP in 2002, it's likely to decline to under 2 percent in 2003.

And I think it's important to note that many imports from China are goods from other Asian economies that are--and this argument is becoming increasingly familiar--so I'm sure it's familiar to most people in the audience, too--but China is processing inputs from other Asian economies and exporting them to the United States. So the bilateral trade deficit with China is exaggerated by the fact that we have less of a trade deficit with other Asian countries than we otherwise would have had it not been for China effectively becoming a manufacturing platform.

I think another element that needs to be noted in thinking about what the impact of the Chinese currency situation is on the United States, that a change in the value of the currency would not, by any means, fully pass through to a change in the price of goods in the United States that contain Chinese elements because a significant part of the price of a good in the United States is not a result of Yuan-denominated factors. A lot of it's marketing. A lot of it is transportation. A lot of the ultimate cost of a good in the United--of a change in the ultimate cost of a good in the U.S. is a result of the change in the value of the Yuan, would not, it certainly wouldn't pass through to a one-to-one relationship.

What's the U.S. policy position in light of these circumstances?

We have maintained for some time that, in general, the--for a large economy that is integrated--a large trading economy, a flexible exchange-rate regime with the values of currencies determined by the market, is the best regime for those sorts or countries. We can acknowledge, I mean a small open economy, there can be benefits to a peg. Although, if it's hard enough and credible enough, although increasingly the ability to maintain such fixed-rate regimes credible argues, even in those circumstances for countries to think about a more flexible regime. But, certainly, a large participant in the international trading system with a lot of trade is going to do better with a flexible exchange-rate regime.

We have made that position very clear to the Chinese. When Secretary Snowe traveled there early in September and I was with him there as we met with various senior Chinese officials and stressed the point that we thought that the economic arguments from the Chinese point of view were very strongly in favor of their moving to a more flexible exchange rate regime.

We also think--and we made the point when we were in China-- that China's restrictions on capital flow represent a major rigidity that's interfering with market forces. And as I indicated earlier, the Chinese understand this, they're reducing barriers to capital flow to developing more open markets. They've particularly taken a number of steps in this area recently; incremental steps to liberalize capital movements.

The Chinese reported outstanding us they acknowledge that a more flexible exchange regime is in their interest; that it's something that they intend to do as they open the capital account. This week, China and the Treasury announced a program of more intensive technical cooperation on issues associated with the currency regime; with the capital account; with the financial sector to discuss with the Chinese the steps that they might be taking as they move down this road.

The Chinese and the G-7 have agreed to have regular discussions on this issue. The first meeting took place in Dubai at the Fund Bank meetings there. Further meetings are going to be scheduled on a regular basis. So, the--I think that active engagement with China is paving the way for progress on this front and on the other fronts that are equally important that I identified at the outset.

What we ought to be thinking about in the United States is ways to manage the integration of China into the global economy in a way that enhances and maximizes the growth-promoting effect of that integration. The currency issue is one and an important element of that overall engagement, but it is only one. And we have a variety of mechanisms to continue that engagement which we will be moving forward with in the coming months.

I think we're already seeing some signs of the success of that effort and we expect to see more in the future.

MR. LACHMAN: Thank you Very much, Mr. Quarles. Let me call on Nick Lardy to make his presentation.

MR. LARDY: Like Randy, I'll try to be very brief so we'll have time for more discussion. Essentially, I want to start by giving a quick answer to the questions that the organizers of the conference posed and then go on and look at an alternative proposal.

Essentially, my argument is, and I agree with almost everything that Randy said; I agree a flexible exchange-rate regime is desirable in the long-run--the question is: How fast can you get there? How soon can you have a sufficiently robust domestic financial system that can withstand an open-capital market and flexible exchange rate which goes with it?

And I begin simply by making two observations: First, the Chinese banking system is, on international accounting standards, massively insolvent. And I underline the word "massively." And I will argue, at the end of my remarks, that it is likely that over the medium term to become even more massively insolvent, because of what's been going on in the last three to four quarters.

The second observation is that the banking system is financed almost entirely from deposits from the household sector of the economy. These now amount to more Trillion RMB and an amount equal to roughly 85 to 90 percent of GDP.

At the moment, about 8 percent of these deposits are held in foreign currency form. But the foreign currency deposits that are held by Chinese households are very, very restricted. It's basically those people that that have income abroad when they have lived abroad and are allowed to bring it back into China and keep it in the form of foreign currency deposits. Or people that live in China who get remittances from their friends and relatives outside of China. They have been allowed--in the old days, they were required to convert these immediately to domestic currency,but since the mid-1980s, they have been allowed to retain them in foreign currency deposits in the banking system.

But for the vast majority of the Chinese public, there has been no opportunity to diversify whatsoever and hold foreign currency denominated financial assets. And I think if they were to liberalize prematurely their capital controls, we would see significant outflows of funds from the banking system as people move to put their money in foreign banks and/or in foreign currency of financial assets of one sort or another. And it's likely, in my judgment--although it's not provable--that this would overwhelm the effects of the current surpluses that China has in its trade account and its capital account. And so the net result might be, first of all, the potential of a domestic banking crisis. And secondly, the possibility, indeed, I would say probability, that the currency would depreciate if they moved prematurely to the floating.

So the answer to the question is, I think, yes, in the long-run; no, in the short-run. And so, it becomes a question of how soon can they get to the point where the domestic financial institutions could support the elimination of capital control.

So, my view is in the short-run, while there is a move eventually to strengthen the domestic banking system and other aspects of their financial system, that they should have a revaluation of their currency. And I just will quickly run through the argument; I think some of you are familiar with it. With my colleague Morris Goldstein [ph], I've written about this and he and I have both spoken on it at a number of occasions.

But, essentially, we begin by noting that china has a fairly persistent current account surplus. It's gone down dramatically the first half of this year. I agree with Randy, and it's certainly will be well under 2 percent, it will be something closer to 1 percent by the end of the year, because, quite simply, the economy is currently in a period of unsustained or unsustainably rapid economic growth; an extraordinarily high rate of investment, which combined with its openness has meant that imports are--the economy is sucking in imports at a very, very rapid rate. Mostly investment goods because the investment rate is very high. But, also, things that are going into process export. But import growth in the first eight months is slightly over 40 percent, which is unprecedented in the last 25 years.

So there is an underlying current account surplus. It's probably much stronger than the 1 and 1/2 percent in the first half of the year because when the investment rate goes to a more sustainable level, the current account will be higher. So, I think the underlying current account is something, maybe you could argue about the details with something, perhaps, as 2 and 1/2 or 3 percent.

They also, of course, have a capital account surplus that's much smaller than the headline numbers of foreign direct investment in-flows, but it has averaged 1 and 1/2 percent per year over the year since the end of the Asian financial crisis.

So, with a current and a capital account surplus, reserves have been building up and Randy's already given you the numbers, so I won't repeat them. I will just make the observation that reserves are actually building up a little bit more rapidly, particularly this year--quite a bit more rapidly than some of the current an capital account surpluses, which simply reflects the fact that money has been coming back into China, and if you look at their errors and omissions in the balance of payments, historically throughout the '90s, this was a large out-flow. It turned positive last year. And in the first half of this year, it's probably positive in the neighborhood of $30 billion U.S., plus or minus a little bit given the infrequency with which the Chinese released balance-of-payment information, it's a little hard to judge. But a good estimate would be around $30 billion.

So there's certainly a widespread expectation in the market that the currency will eventually revalue.

So, this is beginning as, again, Mr. Quarles suggested, beginning to cause significant problems in terms of the growth of lending. And this is just a diagram that shows the huge buildup in foreign exchange reserves, in terms of the pink bar graphs, it's just putting on a monthly basis the data in two diagrams ago and then, also, showing the growth of lending--the RMB lending from the domestic banking system.

And lending has grown dramatically since the reserve buildup began; it has gone from a little over $10 trillion RMB to about $1.5 trillion as reserves have built up.

The Central Bank has been very aggressive in sterilizing the effects of reserves buildup since April of this year. But if you go back and take the whole period, I would say from the beginning of 2001, through the first-half of this year, it looks to me--and the data on this are a little bit sketchy, but--it looks to me like they have sterilized only about a third of the increase in the money supply associated with the purchase of foreign exchange reserves.

So, very aggressive policy since April. But the banks, today, are lending not on the basis of today's reserve buildup, they're doing their lending in recent quarters on the basis of the excess reserves that they built up in earlier quarters. And, indeed, the Central Bank moved to cut that off last month, when they raised the reserve requirements somewhat.

So I'm not saying there's--it's clearly from the diagram you can see there's a high correlation in not claiming causation but, certainly, the buildup of foreign exchange reserves and the increases in these money supply has been a contributor--or, certainly, made possible the growth of lending that we have seen, particularly rapid in recent quarters.

So, this is, essentially, the reason I think that the Chinese will eventually find it in their interests to revalue their currency somewhat. That they should revalue by an amount that would be sufficient to bring their overall balance-of-payments roughly into equilibrium so you would not have an underlying buildup of reserves which, presumably, also lead those people that are moving money into China to the view that, perhaps, that further revaluation would not be forthcoming. And, so, China would be in a situation where it would be able to pursue a more sensible, quite frankly, sensible monetary policy.

At the moment, their foreign exchange policy and their domestic monetary policy are working at cross purposes. And I would guess that the Central Bank is probably already arguing for some kind of revaluation. Of course, first, the politicians don't see what's the matter with a large credit buildup; it's created a lot of jobs; export growth; and inflation is still, at least at the CPI level, you know, in the neighborhood of 1 percent. So, they don't want to end the party soon.

But let me just--to look at this a little more fully--look at the growth of credit that has occurred, particularly in the first half of this year. This is my favorite measure of credit growth in China, it simply looks at the increase in the outstanding loans relative to the amount that's being produced in the economy.

You can see at the beginning--this runs for '89 through the first-half of this year. And the last cycle in which we got inflation up in the mid-20 percent levels in '93 was preceded by a rather large increase in lending, relative to GDP, as you can see as we move from '89, up to the peak of almost 20 percent in 1993.

Gurung Gi [ph], came in to be the head of the Central Bank in July of 1993 and immediately began to implement a more stringent credit policy and credit grown began coming down. There was a little blip in '97 I can't explain. But in the aftermath of the Asian financial crisis, credit growth was fairly consistently under 15 percent and it remained so, I would emphasize, through the third quarter of 2002. I don't show the quarterly data on this diagram, but through the third quarter of 2002.

So, beginning in the third quarter of last year, lending growth has exploded. In the first half of this year, it went up by 1.9 trillion RMB, as compared by 900 billion in the first half of '02, so the amount of additional credit outstanding in the first half was equal to 38 percent of the GDP produced in the first half. The GDP in the first half was 5.005 trillion.

And the Central Bank's newspaper, in an article just a few days ago, said that they anticipate that by the end of the year, credit outstanding in the year 2003 will have increased by 3.6 trillion RMB. So a slight amount of credit tightening in the second half, but not very much. And that would leave us assuming 8 or 10 percent GDP growth, that would leave us with credit outstanding growing in the current year by an amount fully equal to one-third of GDP.

So, basically, in terms of credit growth, we are entirely in unchartered territory at rates we have never seen before in China in the 25 years of reform. And I've asked--and I will ask here--in an audience that's far more experienced than other countries--show me another country where loans outstanding have increased by one third of GDP in one year, you know, I don't think Indonesia, Korea, and Thailand, back in '96/'97 even quite make it to that standard, but I'd be happy to be corrected.

I can't think of any happy medium- or long-term outcomes from this process. There are some nice short-term benefits, but long-term consequences certainly look very adverse to me. I think credit quality must be falling like a rock. NPLs, if properly measured, will shortly be rising significantly. And the prospect that China's going to be able to move towards easing significantly of capital controls and moving towards a flexible exchange rate, which I very much agree should be done in the long-run--it looks to me like it's going to be the receding horizon.

So, I'm extremely supportive of the Technical Cooperation Agreement the Treasury has entered into. There is a great deal of work that could be done.

MR. LACHMAN: Thank you very much, Nick. Yusuke, would you like to--

MR. HORIGUCHI: Well, I won't be either brief or long, just right. And I liked the way Randy sort of put a frame work of thinking about this issue. So, I'm not going to go into it again. But I would, rather, focus on the narrow issue of what the Chinese authorities should do about its own currency.

And I would say the approach that I'm recommending would be good for China, because it will move China's exchange rate into the better direction. And, also, it will allow China to avoid--to [inaudible] a very abrupt exchange rate change that other proposals might imply. And, also, it's good for the international system to the extent that if China is going to do what I think they ought to do, it would been seen as a constructive contribution to the better stability of world financial system. And, perhaps, help avoid the U.S. taking protectionist action.

Now, that I have done the advertisement of the merit of the approach, let me be more specific about the approach itself. I would recommend, as I consistently did when I was heading the Asia and Pacific Department of the Fund, that China adopt a more flexible exchange rate system now. Perhaps, in a phased way of progress it would be widening the band of allowable exchange rate fluctuation. Given the massive structural changes that are occurring there and will be and should be occurring in the future, I believe I'm on very firm ground in recommending this course of action.

I would also recommend that the band defined, vis-a-vis, a basket of currencies rather than vis-a-vi, just the U.S. dollar. Then we add that the progress widening of the band that I am recommending is a process that ought culminate in the adoption of a managed floating exchange rate system. Or, better still, what Morris Goldstein called a managed floating plus.

Some may argue that in the situation such as at present, China would soon face the same problem as it is facing now, under the band regime, because the exchange rate hit the ceiling in no time, necessitating Chinese authorities [inaudible] or to some other things. And this is a very varied observation. However, China would readily cope with that kind of pressure, as they do it now. We should not forget that if we allowed them to do what they allowed to do to keep the exchange rate of 8.3, they can do it forever. Of course, there could be some problems down the road, but it would be a long time in coming.

Now, if I were the Chinese authorities, I would defend the band for some while in such a situation to ascertain that the pressure is really persisting. And once that is ascertained, I would stop considering whether I need to change the exchange rate band or widen the band and, in due course, take action. And this process can be repeated.

And, this way, I could follow an approach of sort of successive approximation towards the right kind of exchange rate where pressures no longer exist. And let me emphasize that going there gradually would be much easier for China to cope with than a sudden large change based on a guess, about what the appropriate size of the jump.

I've heard from experts, including Nick Lardy in Dubai argue against moving to a more flexible system at this time because of the fragility of China's banking system. I want to make a few observations on this.

In the vast literature on the exchange-rate regime, there is a consensus that a country should not opt for a peg if, first, it faces fiscal dominance; and/or two, if it has a very weak banking system.

The latter because, if a banking system is weak, it really can't cope with the interest rate hikes that might become necessary, when the currency comes under pressure.

Now, those who argue against moving from the peg to a more flexible exchange-rate regime in the case of China because of the fragile banking system, should recognize that they are going against this well-established consensus.

Now, given that the remedies under upward pressure rather than downward pressure, the point I just made about interest rate hikes and the banking fragility, might be considered not to be immediately relevant. However, don't forget that some of those who oppose floating of the Renminbi now because of the banking fragility, favor a sizeable, if not a huge, revaluation of the Renminbi and repegging it at the higher level.

In that context, my points about the interest rate hikes and the fragility of banking becomes immediately a relevant issue.

Now, in a related vein, I feel there has been a mixing up of two separate issues. One, capital account liberalization and health of the banking system. Second issue, is adoption of a more flexible exchange-rate regime and the health of the banking system. They are two separate issues.

I need to emphasize here that moving to a more flexible exchange-rate regime, even to a pure floating [inaudible] intervention does not require capital account compatibility.

Now on the first issue of capital account liberalization and health of the banking system, I completely agree that a country should not proceed with capital account liberalization unless the banking system, including prudential regulation and supervisory system is robust. Clearly, China should avoid any significant opening of its capital account at this stage, given the very fragile state of its banking system.

I'm afraid that if China is opening its capital account now, gradually as it may be, basically to slow the pace at which reserves get accumulated. This is a wrong approach.

Now, the second issue: When it comes to the choice of the exchange-rate regime and the health of the banking system, I submit that a strong banking system is needed more in the case of a peg than the case of a flexible regime. Although, of course, a strong banking system is needed or desirable in both cases.

In other words--and as I said earlier--I don't agree with those who argue against a float for China now because of its fragile banking system. I wonder whether they are not mixing up this issue with the issue of capital account liberalization and banking fragility.

I realize that the flexible regime will introduce currency fluctuations as another risk factor. But that should be dealt with by prudential regulation on banks to avoid an excessive currency exposure.

There is a fear of floating in parts of Asia, but this is--this theory is not warranted. And China should not get into this trap of fearing the unknown. I remember that Sri Lanka and, also, Bangladesh did not want to float even when they had very little reserves to defend their pegs which were under tremendous pressure, on the ground that they did not have good enough market infrastructure for a smooth functioning of a floating system. And, also, their banking system was very fragile. However, they told me later, after shifting to a float that they experienced no problems and they adopted a float.

Although I am not recommending an immediate floating in the case of China, the point I have just made applies with an, actually, stronger force to a phased introduction of greater flexibility. No fear is warranted.

Finally, let me stress the need for China to dismantle certain restrictions which are hindering the functioning of an exchange markets. These will stand in the way of an efficient functioning of a floating or flexible exchange-rate system. I will cite just a few of these restrictions and suggest what needs to be done about them to illustrate the point: First, firms needing to buy or sell foreign exchange, should be allowed to deal with any authorized foreign exchange dealer, instead of being assigned to a specific bank at present.

Second, the number of banks authorized to participate in the foreign exchange market, should be increased significantly from the current very restricted list.

This concludes my remarks, thank you.

MR. LACHMAN: Thank you very much, Yusuke. And I just want to assure you that it wasn't too short or it wasn't too long. I turn now to John Makin.

MR. MAKIN: Thank you, Des. I noted exactly how long your presentation was. So I'll keep it there.

MR. HORIGUCHI: How long was it?

MR. MAKIN: Perfect. You know, I think I share the diagnostic side of most of the speakers' comments. And let me try to state the diagnosis of the issue that surrounds whether China should revalue its currency.

I would replace the word with will. I think there's, perhaps, a sense of urgency here that I would like to convey. It's not as if the Chinese are gently thinking about turning a dial that says let's make the currency up or down here. Things are going on and I think they're emphasized in Nick's presentation that raise a certain sense of urgency here.

China is--looks to me like a classic case of an undervalued currency. Either in any big model of the world, either exchange rates are endogenous or money supplies are endogenous and, in this case, the exchange isn't allowed to adjust, so the money flows into China. The Chinese are trying to sterilize the inflow of money because they're having a massive increase of credit through a banking system that's already insolvent, as Nick has suggested. And having limited--

[Tape change: T-1A to T-1B.]

MR. MAKIN: --China is heading for the third-bubble syndrome. We had a bubble in Japan in the '80s. We had a bubble in the U.S. in the '90s and it looks like we're building a bubble in Japan in the '00s, simply because the currency is undervalued. The banking system is very aggressively expanding loans. And China's in a way, you know, like a goose that's being stuffed to make fois gras, nothing can come out. I mean, the Chinese savers cannot say, oh, lots of liquidity, I think I will take some money and go someplace else. The money's going into China, Central Bank, again, is trying desperately to sterilize it, not succeeding; creating what looks like to me a massive bubble, probably in the property market, that will explode pretty soon with bad consequences.

And here, you know, you might say, well, this sounds like the Asian crisis of 1997. It's not, really, because here the victims will be the savers in China, whose funds are trapped in the Chinese banking system, not the foreigners who've chased funds into China.

So, this is a kind of a background issue. Then, let me introduce another factor: That is, that after Dubai for better or worse, the perception emerged that the United States was not longer passive about the value of its currency. That it would prefer to see currencies determined in markets and that means that if you are intervening heavily, as the Japanese, Chinese, and other Asian currencies are doing, your currency should appreciate.

Now, the problem with this is that if the other side of this dollar depreciation occurs, which, perhaps it should, perhaps, it shouldn't, the markets seem to think it should. It's essentially a zero-sum game for the global economy. But if one country, China, which is a big trading country says, I'm not moving my currency, it's a profoundly negative-sum game for everybody else, especially other trading economies in Asia. So a certain sense of urgency emerges here.

So, it seems to me that there are international reasons having to do with currency movements which are occurring in a world where there's some excess capacity and domestic problems that are emerging, quite predictably, with a currency that's undervalued that's creating a huge surge of liquidity that exceeds the ability of the Chinese authorities to sterilize. And, of course, the sterilization simply means that the adjustment that needs to occur when there's an excess demand for currency in monies flowing into the country, the adjust process if you peg the currency would be inflation, faster growth, all things that would make people want to send money out. But the Chinese can't send money out, so the process goes on and they spend more and more on assets inside the country, until the return on those assets at the margin is driven to zero, against promises to pay lenders who've invested in those assets. And that's the definition of a bubble that explodes when that's widely recognized.

I'm certainly aware that China has the means to suppress this kind of a crisis for longer than most, but that only means when it breaks out it'll be considerably worse.

So, I guess, if I see a system--and I agree with Nick--that we've got a system where the rate of increase of the insolvency of the banking system is positive--and probably accelerating--this is a problem that needs to be addressed fairly promptly. And a way to start would probably be to float the currency.

I'm a little uneasy about a new peg, because I don't know where it should be. If you set it too low, then you go right up to the ceiling and you're right back where you started and so on and so forth. So, you probably need to have a transition period, but something's got to be done here or there'll be a nasty explosion in China.

Not to mention the tensions on the world trading system. You know, in school, we learn about factor-price equalization, but an awful lot of capital's going to have to move into China to push the price of Chinese labor up to global levels; probably an unstable amount. And that would imply some unpleasant responses on trade policy elsewhere.

So, yes, China should let it's currency float. Yes, it should get started on the process very soon. And then after the currency's floating, should start to dismantle capital controls so the Chinese savers have access to something other than bad loans in China.

MR. LACHMAN: Thank you very much for that sentence. I just should mention that John Makin really does have a lot of expertise in bubbles in different places. No less than Japan. So I take it very seriously what he's put on the table. I now turn to Harvey Chen.

MR. CHEN: I have quite a few points, but most of them have been addressed by the speakers. I want to go back to the issue of the topic of this session, Should China Float?

I think there is a sort of a long debate between economists now whether a floating regime is better or a fixed regime is better. But I think in the end it doesn't matter. I agree with Yusuke's point that, you know, the government tend to fear to go into floating, but once they float, you know, they're happy.

A primary example is Britain before the pound was forced to float by [inaudible] and the like before the float, John Major was swearing on the TV that this ERM, exchange rate policy, is an irrevocable principle of this government. But, then, you know, once they are forced to float, they live very happily ever after.

[Laughter.]

MR. CHEN: So I think there should be no fear of moving into a floating regime. The issue now is for any fixed-rate regime, the government always wants to stay firm until the last minute, for fear of various things. But here in China, maybe something might be justifiable. Nick's point on the banking issue which is a huge issue and I agree with him entirely on the current accumulation of debt of credit through the system; primarily directed to the real estate, which could become even more bad loans in the future. And that government is trying to do something by raising the deposit, the bank deposit--reserve deposit rate. That's already having a big effect on the banks--their liquidity. They're feeling the pain already. But the negative side of that kind of sort of across-the-board rising interest rate is at the consumer sector, which has been very weak since the Asian crisis has never fully recovered, it's going to be hurt, not the real estate.

So, the issue is, when you implement an instrument that has a broad effect, you hurt certain sectors that you want to protect. So this principle applies also to the exchange rate. So, if we go to the bottom of this debate on the Chinese currency, we see that there are certain countries [inaudible] some gain situation that feel that this is unfair, that China is not sharing the burden of the global adjustment.

And then, within the U.S., you will see certain sectors of industries feel the pain more than others. So there are different issues to be addressed.

But, then, if you use this tool to engender it, you will see that you have undesirable side effects, which might overweigh the other side. So, I think that's the argument. So, if you take the U.S. industries, as an example, most of the multinationals in China, they favor sort of current status quo, they don't want to see changes. Just like the government doesn't want to see changes. They don't want to see changes because there will be more uncertainty about the exchange rate; about the investment.

And there was a study, sort of a simulation, by some Oxford professors who showed me that if the RMB appreciates by, say, 20 percent, then the Chinese trade with the U.S. will be affected. But three-quarters of the effect will be borne by U.S. multinationals who set up the manufacturing base in China. So, to them, they don't quite see the gain of appreciation. But to certain companies in the U.S. who are not globalized, they would benefit from it. So, the net result is hard to say, you know, whether this is overall beneficial to the U.S. or not. So that has to be a point that we will need to keep in mind when we think about exchange rate as a possible policy. Some sectors will be hurt, some will benefit from it.

But I think the one thing that is missing in the whole debate is that for those industries or companies that are left behind in the globalization process. they need help, okay. The exchange rate help them, but that may not be the only instrument, there might be more.

For example, you know, Japan asked China to appreciate. But, then, you know, would that help Japan? Because Japan's fundamental problem is with the banking sector problem with the reforms that need to be done. And a temporary Chinese currency revaluation would not help eradicate the problem.

The same thing is for Southeast Asia, they have to make the adjustment.

So, this is something that we have to keep in mind. This tool is too powerful but it may hurt certain other aspects.

Now, coming back to China, I think the leadership--I am under the impression that they are quite sensitive to international demand and pressure. They are trying to play a positive role in the international community to be seen as a responsible big nation. So, I think they are taking this demand under sort of a, you know, taking a serious look at it. And that's my impression, even though, publicly they don't say that. They don't want to be seen as being pushed around by the big countries. So, I think they are working actively on [inaudible] strategies, moving more into, maybe a [inaudible] pack.

But in implementing all these kind of things, I think that the question is not whether China should float or go to a more flexible exchange regime in the long-term. In the long-term, for sure, even the currency should appreciate, it's the transitional period that is more challenging to them, given the fragility in the banking sector and, also, many other problems in the system than we have in the outline of this session that there was a state enterprise problem that creates a lot of unemployment, 10 million unemployment a year, no country has handled that in history without a big chaos. But, so far so good, but this could still be a potential time bomb.

This is the huge problem with the farmers, the agriculture sector, 800 million people. They are poor, they are not gaining much from this whole process. So that's the number-one issue actually facing the country. But it's not as tricky and technically challenging as the banking issue, which, you know, there's no experience, there's no technical issues to solve that, it happened so quickly. So, that's what I think comes back to Nick's point, you know, that's the number-one issue financially.

Then, if we think about whether a Chinese currency change will actually deliver short-term benefit to countries that want the change, the issue is uncertain because what we want is a trade account adjustment. So, maybe a 10 percent revaluation will result in some trade benefit, but this comes very slowly, maybe takes months or a year. But what happens real quickly is that the capital account and the financial market adjustment, which tend to overshoot. So there might be an overshooting in interest rate in the U.S. as a result of a Chinese adjustment on the bank holding of the U.S. Treasury bonds.

So this could be an issue that could run against the argument. So I just want to caution that we might not see an immediate benefit if we do that. So the end result is that we might encourage China to take its time to actually make a proper and sort of a more permanent adjustment to a new exchange-rate regime. So should be flexible--could be floating or could be just flexible within a band. But that mechanism has to be carefully studied and technically more competently implemented.

And I'm glad about the Treasury Department is cooperating with China on that. And, also, I would like the international economics profession to help China on this, you know, on the technical side.

MR. LACHMAN: Thank you very much, Harvey. I'd like to throw this open to question. And I think that we'll take questions from the floor. But beforehand, you know, I've just got to say that this discussion was pretty rich. There were very many different views expressed to me. It seems to me that there's agreement as to where China should be going. It looks like what the agreement is is that China should eventually have a very flexible exchange rate, probably in terms of a float; that they should have capital accounts open; convertibility as an ultimate goal; that they need to strengthen the banking system.

Where I detected, though very big differences in view across the table, I think were on two issues. The one is the famous sequencing issue, you know, do you open your capital account before you pick the banking system? When do you float. The sequence of the reforms that you're wanting to do to get to that position. That was the one issue.

And then, of course, you know, I seem to have heard three or four different versions as to the transition in terms of the exchange rate. You know, we heard views of Nick Lardy, on the one hand, you know, talking about a step appreciation of the currency. And, then, you know, moving towards bands. But then we also heard, notions of, you know a small band to keep moving it or, alternatively, just floating the currency.

So, I thought that, perhaps, if I could run to Nick Lardy and Randy Quarles, ask them just to respond a little to points of Yusuke's [inaudible] of the Lardy/Goldstein proposal, you know, what are the counterarguments to that. And, perhaps, if Randy, you could just give us a little bit more of an idea of what Treasury's thinking is, you know, in terms of the sequencing. We know that we want everything in the end, but how do we get from point A to point B. And then, you know, if anybody on the panel wants to respond and then I'd like to throw it open to question.

MR. LARDY: Well, I guess I'm a little bit skeptical about proposals that the currency should float, while you leave all the capital controls in place. I mean, I guess one can point to examples where this is done. But, I mean, the whole idea of floating as a market-determined rate, but if all your capital transactions are heavily controlled, you really don't have a mkt- determined rate.

And the second, the criticism that was directed to the revaluation proposal was, in part, that there are some difficulties in knowing how much you should revalue. But I think we can make a reasonable guess, you can discuss what the various parameter values are--and Morris have done this--it's something in the range of 15 to 25 percent. I don't think it's anywhere near 40 percent.

After all China's, the sum of its current and capital accounts is not that large--their surpluses--so the amount of adjustment that's required, even taking into account the large import content of exports is unlikely to be anywhere above 25 percent. I think the risks of floating without--floating and leaving all your capital controls in place, is that you will attract more capital inflow on the expectation there'll be further revaluation. And I think if you do a big enough step that makes it clear that the underlying balance-of-payments is going to be an equilibrium over the cycle, then the incentive for speculative money coming in is completely undercut and you have much more credibility.

So, I think there should be a medium-sized revaluation. I agree, once you do that, there should be a wider band, as well, and the peg should be not just for the dollar, but to a basket of currencies. So, I think the way to go is revaluation with those two steps. And, then as you can strengthen your domestic banking system and gradually liberalize capital controls, you can move towards a much more flexible system.

MR. LACHMAN: Thank you Nick, Randy.

MR. QUARLES: Sure, on the sequencing question, I think that we--I mean, it's clear that we acknowledge that there are, you know, there are a variety of steps that China can take and wants to take to improve the environment in which it can move to a more flexible regime. But we don't think--I mean, some of these, such as the full strengthening of the financial sector are huge tasks.

And we don't think it's necessary to complete those tasks before China could move to more flexibility. I take the force of Nick's point that, I mean, if you put yourself in China's shoes and if the international community were saying, well, just let your exchange rate float and you don't have to do anything on the capital control side--they's say, well, but then, that is as an artificial a regime as we are in currently, but it would be one in which our currency would be artificially high. Why should we do that?

So the, you know, so our message to them has been, therefore, do both. You can move simultaneously to increase the flexibility of the exchange-rate regime and to open the capital account. While doing that, you need to move on these other fronts, but it isn't necessary to solve all of these other problems to believe that you have an invulnerable financial section before you move on these other fronts.

I have one, it's a genuine question that I'd like to ask about Nick's interesting--which is something that concerns us--this loan growth. But particularly the last chart. And it's a genuine question. I have heard some people estimate, the Treasury doesn't have an official view on this yet, but some people estimate that while China's GDP figures were, perhaps, overstated in the past; that recently, they're probably understated. And some people think they're significantly understated. If you were to say, as a result of that that the loan-to-GDP ratio as artificially low in some of these early years because GDP was being overstated and high recently, because GDP was being understated--and, in fact, some people think it's being understated by, you know, not quite--rather than the 8 percent I think they're looking at may be as high as 13 or 14 percent--that would result in ratios that were much closer to even than this chart would show.

I don't have a view as to--I don't have a strong view as to the accuracy of the GDP figures or if they're off, how much they're off. But it would be interesting to have people's--have Nick's view as to how that would affect his assessment of the situation.

MR. LACHMAN: Nick, yeah.

MR. LARDY: Well, I, let me begin by saying, I think I certainly share the view--although Randy was careful to say it's not his view--I share the view others have expressed that the growth rate in the first half of this year is probably several percentage points above the official number. I don't know if it's 13 or 14, but I'd certainly be prepared to believe, you know, something over 10.

But--and it may have been somewhat overstated in earlier years. But I still think--I've made some crude calculations, you know, even if you add on a few percentage points to the growth this year and take away or add on a few in different periods and try to smooth this out, I still think we are in uncharted territory this year; that there's a huge discontinuity, you know, maybe slightly less than what's shown in the diagram--the last diagram, but, I mean, we are going to be at--my figure for throwing out 33 percent for this year is 3.6 percent in terms of $3.6 trillion in terms of increase in stock and loans outstanding--and I'm already assuming a 10 percent GDP growth for the year; 10 percent on top of last year's 10.2 trillion, would make it basically an 11 trillion RMB GDP and, you know, maybe a little more. So, it's going to be at least 33 percent this year, which is still going to be way, way, way above anything in the past. So, it could change the story at the margin, but I don't think the fundamentals change.

MR. MAKIN [?]: I agree with the notion that as you move toward floating, you have to adjust or allow free movement of capital. I think that it has to be recognized that it won't be easy, in other words if you do the wrong thing for a long time, it's like defusing a bomb, it's rather difficult to do. However, it's better to try to defuse it than let it blow up; that's one point.

The second point is that the peg, I don't know what happens to people on Massachusetts Avenue, they just can't stand floating exchange rates, but the peg won't help. If you move the peg, under current conditions, you'll snap to the top of the peg; at the top of the band, given the--I mean, I don't know where you'll ultimately end up, but I don't see how that helps you, because it makes you guess what the equilibrium exchange rate is and nobody knows what it is.

So, that's why I have a problem with that approach, but it may be the one that ends up being taken.

MR. HORIGUCHI: I believe that if you flood the currency with the capital controls in place, you'd end up having a rate at--a somewhat higher rate than would otherwise would be the case. But, you know, what I'm talking about is two things; what you can do in a sort of appropriate sequencing. And the--I don't really believe the guessing what the right kind of change in the exchange rate would be at this time and sort of repegging it at that level, would really solve the problem. I think it's best that we sort of let China start doing he right kind of thing, in terms of projection. You reach China ultimately going in terms of the exchange-rate regime. And as they are able to clean up their banking system, okay, start opening the capital account, as well. But, you know, even if it may be seen as an artificial construct, when you talk about floating the regime with lots of capital controls, then it's not historically unprecedented. Japan and, also, the U.K, until 1978, had a very heavy capital control that was dismantled by Thatcher and if you remember--of course, in the case of ERM, through 1990 or somewhere around there--although within the groove it was fixed, but that currency block as a whole was floating with lots of capital controls on huge countries like France, Italy. So, it's not at all historically unprecedented and artificial as it may be, it sometimes works.

MR. CHEN: Yeah, I think there are two issues here we are talking about. One is what kind of exchange regime would be more suitable for China, whether it's a band or floating or whatever. But the other thing I think more important for the whole debate is to whether China should revalue by a sizeable amount by whatever means, by a wider band or by a one-time jump. I think these are two separate issues. And on the latter, I think there is a small debate or controversy on the form is more of [inaudible] issue. So I think these are two separate things. And on coming back to the latter, China is identified as a country that needs to make the judgment. Quite easily because this is a whole part of the globalization process. The whole Washington consensus, like it or not. Made the capital and investment mobile and made the transfer of technology more easily. So, amount or other factors of production, only land and labor are less mobile. Land is always not mobile. So in the whole process you will see land will pop up, land price will pop up in certain countries, like certain areas, like in Japan sometimes, and now maybe in Beijing and Shanghai. And also for the non-tradable sector where labor is important, you see the U.S. Medicare and U.S. health care price rocketing.

So these are the necessary results of globalization. And I think the whole movement of manufacturing to China and other countries is part of the adjustment. And in countries like China and other developing countries there are painful adjustments to be made and that they are making the adjustment. For example, if a U.S. company decides to switch the order from China to Indonesia or vice-versa, you will see a huge adjustment of unemployment at the manufacturing level.

But at the same time, the U.S. is also facing this kind of adjustment for companies that are not globalized, that are left behind in the process. They feel the pain, that's why they are asking for exchange-rate policy changes.

But I think to address this kind of problem, again, we need more pointed tools to help them better integrate it into the global system or to help and retrain to readjust, things like that. That's a more efficient way to do it.

But, on the other hand, even the globalized companies, the multinationals that are benefitting from this whole process, should also offer some help to those that are left behind.

And, also, even for the manufacturing companies that are globalized and they are willing to go out, they also face the challenge of ever eroding prices, because of the competition from countries like China, you know, because the labor supply in China is almost infinite with zero-opportunity costs. So there's no way a chance that they can compete at whatever exchange rate level, even if you revalue by 10 percent, it doesn't matter, you know, on the labor cost side. It's only in the U.S. market national profit margin will erode by 10 percent.

So, in that sense, these multinationals are also facing the challenge of lower and lower production prices and also higher and higher cost of benefits, like medical benefits and other things back in the states for their employees. I think that's a challenge that has to be managed in these kind of isolated industries that are not subject to a factor or mobility also needs to be somehow changed.

And so, that will help solve the problem that we are--that were brought up through the debate.

MR. LACHMAN: Thank you. I'd like to throw it open to the floor. You know, if I could ask when you ask a question if you could identify yourself and if you could also identify to whom you're addressing that question. Peter.

PETER: Three of the five panelists have taken an operational position and made specific recommendations as to what should happen on the exchange rate. And I have a question on all three of them, if I may. Mr. Horiguchi said the best way to go is bit-by-bit, widen the band and, perhaps, de-link from the dollar and so on. My question to you, sir, is once that becomes policy and known to be policy, how do you avoid an even bigger problem because you will get all the speculative money in as soon as it becomes a known policy and that's precisely the problem we're dealing with.

Mr. Makin recommends float now and he later on conceded that you'd have to open the capital account at the same time or substantially. Now, my question to you, sir, is how do you know that floating now will achieve what you consider the desired result, namely, an appreciation? In your presentation you also said that one of the big problems in China is that the Chinese depositors cannot take their money out, they were captive. Now, if you open the capital account, if your analysis is correct, surely, there is as much chance that the money will flow out than money will come in. If a lot of money would flow out, that would achieve the exact opposite result of what you aim to achieve, namely an appreciation; a depreciation is entirely possible if we follow your advice.

On Nick's point, go for a fairly sizeable up-front revaluation somewhere 15/25 percent, and then de-link can go to a more flexible system thereafter. That's based on the premise that you can calculate somehow the extent to which the exchange rate is currently undervalued and that you'd be able to correct that is a discrete appreciation. What is your basis for suggesting that the current exchange rate is undervalued by somewhere between 15 and 25 percent? Because in your presentation, you also stated that the current account is coming together this year, maybe 1 and 1/2 percent. We've just heard yesterday that the Chinese are reducing the export subsidies or the export rebates by an average of three percentage points, which will have a fairly significant impact, I think, on export gross. And a current account deficit in 12 months from now, would be entirely possible. So what is your basis for suggesting there is an undervalued exchange rate based on current account evaluations? Thank you.

MR. LACHMAN: Thank you, Yusuke, would you like to start?

MR. HORIGUCHI: As I said, that's a valid point in my presentation, actually, there would be a situation of the kind that you are describing was the kind of process that I described as a desirable course.

Now, in terms of the degree of pressure that the currency would be subjected to, I would have guessed it won't be all that different than the pressure that the currency that is pegged and be seen as completely valued to be subjected to. So to the extent that gradually over time, this process, despite it's defects, gets sort of adjusted toward a better aligned exchange rate, pressure ought to subside over time.

MR. MAKIN: The question to me is to suggest how do I know what will happen to the currency if we let it float and then allow capital to flow freely? We don't. I would say that, as a speculator, if they let the currency float tomorrow, irrespective of what they do with the capital controls, I would bet on the currency rising. I might be wrong. What--the reason that I would do that, would be that first of all, although there are capital controls, I suspect that there are many wealthy Chinese who have a little money outside of China already.

And secondly, if China is still a very attractive place to invest because capital combines very nicely with very low-cost labor, I'm not sure there would be a massive outflow of funds. But it's, you know, again, I think the market would decide where the currency would be as it worked through all these things. I've been a little bit surprised in Japan, as restrictions on capital outflows have been relaxed, how little effect it has had on the currency.

But, here again, it would be new territory, but that doesn't say we shouldn't do it.

MR. LACHMAN: Thank you. Nick?

MR. LARDY: Peter's question, in essence, is how do we know the currency is undervalued. And I think--and by how much. I think it's very clear the currency's undervalued, the leadership has admitted it already, basically, under the previously existing institutional arrangement, the currency is undervalued.

We have the buildup of reserves that several of us have talked about. But we also have the steps that China has taken to try to ease pressure on the reserves by liberalizing tourism; talking about a qualified domestic institutional investor program; allowing Chinese firms to retain more of their foreign exchange earnings from certain kinds of service transactions, which has already taken effect since September 1; liberalizing outflows of foreign-direct investment. So, certainly under the then existing arrangement, even the leadership understood the currency was undervalued. The question is how do you deal with it, can you make some ad-hoc adjustments of the type I've just spoken about and get rid of the pressure on the currency? Or do you have to think about revaluation or flow.

I am a little bit on the skeptical side that the ad-hoc or what I would describe as ad-hoc measures are going to work in the current environment. I don't think very many Chinese firms are going to be rushing to invest abroad today, when there's a widespread expectation, you know, they could wait a couple of quarters or more and make their foreign investments at a much more favorable exchange rate.

So, I think on a lot of these partial liberalizations that have been taken, the uptake, if you will, is going to be quite small. And so, under the current arrangements, I would expect to see, as we saw in recent months a continued buildup o s foreign exchange reserves.

Now, how do we estimate it? Yes, the current account has come down very substantially, but, as I indicated--perhaps too cryptically in my remarks--I think the underlying current account--that is the current account over the business cycle, if you want to call it that--is much more than the current 1 and 1/2 percent. And Morris and I estimate, roughly, that if you got back to a sustainable rate of investment that that would add three-quarters of a percentage point to the current account, you'd be at something on the order of--and the second adjustment, I should explain, is that China by virtue of its peg to the dollar--in recent five or six quarters, the dollar has come down on a trade-weighted basis. And given the fact that these price effects take time to feed through to the trade flows, China, presumably, will benefit from that as we go forward. It's not all factored into the data we see today. And we just ballpark estimated that that might be another three-quarters of a percentage point of GDP.

So, our view is not the currently observed current account which is coming down dramatically, but the underlying current account over some, you know, longer period of time, is probably something on the order of 3 percent. And so, in a simple trade model as you take some reasonable parameter values, you have to do something on the order of 15, 20, maybe, 25 percent to bring that current account down to zero or maybe even bring it down to a negative number, because there seems to be an underlying capital inflow of about 1 and 1/2 percent. Now, that is based on the assumption that they largely, at least in the short run, maintain their current capital control regime.

Obviously, as you go forward and can strengthen your domestic banking system and liberalize and, you know, once you have a wider band, then you may move from the initial revaluation

But I don't, I think one can make a reasonable estimate of what the desired amount or needed amount of exchange rate change is, at this point.

MR. RHEINHOLZ: I'm Arnold Rheinholz [ph], the permanent representative of the European Central Bank in Washington and it's observer at the IMF. I would like to come back to the multilateral aspect of this issue and a number of speakers pointed that out. I think it's very much multilateral issue. But first, maybe also following the previous speaker, I think I recall that sometime after or around the Asian crisis, the then chief economist of The World Bank suggested that the Renminbi issue be devalued. If that had happened, we would have even more problems today, I think.

But coming back to the multilateral aspects of it, I do believe that it's important to keep in mind that it's not only a U.S./Chinese problem, indeed, and that other countries are affected--countries in Asia, but, certainly also in Europe. And in Europe, there is a degree of, well, let's say concern that if this issue is very much forcefully put on the table that China should do something about it's exchange rate or be it floating or a discrete jump in the exchange rate there could be some important ramifications elsewhere.

And, particularly, the concern is, of course that if China is doing nothing for the time being, and the dollar does go down, a lot of the pressure will simply go to the Euro because, also, of course, as we know, Japan is intervening heavily. This is a concern, particularly in view of the weak economy in Europe. I'm not saying the Europeans are not to blame for some of their weaknesses, there's a strong need for structural reform, obviously. But in the situation where it's just coming out of weakness, and there are some encouraging signs a very strong appreciation of the Euro would not be helpful, I think.

So, what I really wanted to ask, I think particularly to Mr. Chen on this matter is: How does he see a reaction of the Japanese authorities? First of all would the Japanese--the Chinese authorities--would the Chinese authorities be open to a large discrete revaluation. I don't consider, by the way, 15 to 25 percent as a medium-size revaluation, I think it's a big one. How would they--would they be open to this sort of thing? And how--what is the most effective way to approach the Chinese authorities in terms of putting pressure or, maybe, I heard you say, Mr. Chen, China needs to be seen as a big responsible country--is that sort of approach, maybe the quiet diplomacy approach going to be more effective? That is what I'd like to hear, thank you.

MR. CHEN: Thank you. I think this is a good question on the multilateral content on the European side. Yes, for any--not only for China for any exchange regime, the authorities would like to say, you know, just as it is, they don't want to change. So without external force, they will never change. So, that's very simple.

Now, China is in a stage that they want to focus on domestic economies. They want to have a peaceful international environment. So they want peace and they want to have this sort of conducive, supportive environment with the world, especially with the U.S. and the EU and Japan and its Asian neighbors. So, in this regard whatever proposals are put forth to China, they will consider. That's my opinion. And the way I think, you know, they have seen enough political pressure. They are trying to respond to it, but I think their preferred approach is they can buy the time and things might pass and that would be the best option. But if not, then they may way to do some changes along the line of a wider band.

But that's not the answer to the international demand, I think, widening the band to 2 and 1/2 percent or 5 percent, will not really deliver the kind of thing. So the pressure will continue. So that's not sort of a long-term solution.

A discrete jump is more difficult, I think in their mind. Because right away, you know, there would be a lot of adjustment to be made. A lot of companies under their protection of the fixed-exchange rate will have a lot of trouble. I'm not saying that their demand is justifiable, I'm saying that the government will face domestic issues, but the argument for the banking [inaudible] is more valid, I think.

So, in the end, I think they will try not to do a discrete large jump, but diplomatically, they may want to deliver the sort of gesture that they are waiting to change by allowing the bank to be widened. I think that might be the most likely outcome.

But I think this is a good time for China not to be complacent, you know, to buy time, but, really, to seriously thinking about changing the whole regime to a better one; one that responds to the market better, more flexible. In this regard I think that the future pressure on China might be better to be the ones that are more constructive and are more technically oriented rather than politically oriented. Just say you want to move from A to B, how you are going to do it in a way that you keep domestic stability, but also, benefits to the world. I think that must be the tone when you deal with them.

MR. MAKIN: I think this last exchange always leads me to ask a question would anyone from a country that would like to have a stronger currency, please raise their hand? Where are you from?

[Off microphone, [inaudible]]

PARTICIPANT -- a country's financial market has to be relatively strong to allow a floating exchange rate and liberalization of capital control. Now, if you look at the entire capital flows of the world. The United States experience is the largest in inflows and outflows. So, yet the U.S. market is not very much affected by the large inflows and outflows, and that's because the U.S. financial market is very strong and the investor base is huge.

But if you look at China, the financial market, let's look at the capital market. So, two U.S. companies capitalization is larger than the entire Chinese capitalization. So, what does that mean? That means any large inflows and outflows can easily topple the financial market, can charge huge financial instability, so that's why, I would like to hear your views on the following issue: That is, is the financial market development a condition for capital liberalization of floating it's exchange regime.

MR. MAKIN: Well, I'm afraid you ruined my point, which was simply to say, that nobody wants a stronger currency right now. And I take your comments to be along with that, because there's a lot of excess capacity in the world and that--

MR. LACHMAN: Maybe you should have confined your question to a people in the official sector--

[Laughter.]

MR. MAKIN: Maybe I should have, but, yes, exactly. But the point is, there's a lot of excess capacity in the world and when you have a very low-cost producer, like China, you create some problems. And that raises an issue for everybody and that's part of what's going on here; that there's excess capacity globally. The United States is very anxious to have rapid demand-growth at home and is not prepared to be totally passive about the level of the currency as it has in the past.

So, we're here talking about China.

MR. LACHMAN: Did you want to say something, or--

MR. LARDY: I just wanted to explain. The comment was made that 15 to 25 percent is not medium-size, it's large. But what I want to say is we came up with that number, in part, because the import content of Chinese export is extremely high, particularly for a large economy--

[Tape change: T-1B to T-2A.]

MR. LARDY: --percent, so on any revalues, you know, the flows through to the price side on the exports is going to very substantially mitigated because the imports will become much cheaper.

In our simple approach, if we had ignored the effect of the processing effect, our recommended revalue would only be between 10 and 15 percent. The number does seem a little bit on the high side, particularly the 25 percent, but a great deal of it is not because we think the underlying balances are so large, but because of the process affecting it.

MR. WONACOTT: Paul Wonacott [ph], University of Maryland. A number of people on the panel made the point that the current Chinese financial situation is quite fragile, but they drew quite different implications about it. And that's, of course, the question, what does it mean for the desirability of a float. And I guess I'd like to ask my question to Mr. Lardy. You took the position, as I understand it that the fragility of the financial system means that it's not appropriate in the short-run or in the near future to have a flexible exchange rate, and that's the position which one reads in the financial markets. But it's not exactly obvious to me why that is so. And I wondered if you could sort of spell it out in a bit more detail, why exchange rate flexibility would make the fragility worse, particularly as the present peg is presumably one of the causes of the great increase in loans which tends to make the system more fragile?

MR. LARDY: Well, there are really two reasons for thinking that the flow--and just to repeat what I said before, I associate a flow with a substantial easing, if not elimination, of capital controls.

First is I think it would raise, substantially, the prospect of a domestic banking crisis. I mean, the Chinese banking system is--has been and is best characterized "insolvent but not illiquid, " very high savings rate, very few alternative assets available so the money just keeps pouring into those few state-owned banks, you know, month after month, quarter after quarter. And no matter how bad the lending decisions are, you know, they can keep carrying on.

The minute, you know, John's hypothesis comes to pass and people can take their money elsewhere, these insolvent banks will also be illiquid. So I think the first problem of capital account liberalization in the current environment is that it raises significantly the possibility of a domestic banking crisis. Maybe a domestic banking crisis is inevitable anyway, that's another question. But it certainly raises the prospect.

And, secondly, I do think it would--at a minimum, it would lead to a depreciation of the currency, which would move China into an even stronger overall balance-of-payment surplus. So they'd be moving in the wrong direction if they tried to maintain the fixed rate, it would feed back into even more growth of money supply and so forth.

MR. LACHMAN: But it's not a mismatch of assets and liabilities that makes a floats implausible if you maintained the capital controls?

MR. LARDY: Correct.

MR. PRIG: Ernie Prig [ph], Manufacturers Alliance. The point made by Mr. Makin is very interesting, these days, nobody wants a strong currency, which is rather different from a few years ago and for the U.S. until a few months ago, the consistent U.S. policy--and I would say, well, why not, because I would think the basic approach would be, if you have a large current account surplus, plus an inflow of long-term capital FDI, you're in a position to have a stronger currency. The U.S. is not in that position. And shouldn't it be in your national interest on--not so much in terms of the transitional pluses and minuses the banking sector, which has been all the fascinating discussion today. But it boils down to the basic terms of trade.

If you've--if you're in a very strong position, if you revalue 20 percent, this is the whole rationale for a strong dollar the last 20 years; 20 percent stronger, it means better for your consumers. It means the import price of oil, which is a big issue for China and the U.S. is 20 percent less throughout your economy.

So, if you can just kind of get through the transition in the banking sector, isn't there any consideration in China or shouldn't there be, that a 20 percent--I'm just using that as a--20 percent revaluation means 20 percent plus in terms of trade, per capita income is 20 percent higher, vis-a-vis, the rest of the world; their consumers are 20 percent better off vis-a-vis; and the price of oil goes down 20 percent throughout the cost structure of the economy. Shouldn't this be a consideration in this internal whatever appraisal within the Chinese economy, or Chinese government.

MR. HORIGUCHI: Any simple kind of macro model, like ISLM and balance of payments curbs, you know, balance of payments curb would shift to the left with the revaluation of the currency which will tend to reduce the level of economic activity in any event.

And if the country concerned is worried about the short-term consequences on economic activity and jobs, obviously, they're not going to have a strong currency.

MR. MAKIN: That certainly was not the case for the U.S. in the late '90s, the currency appreciated and the economy surged. I think the problem is it's very complicated to know what's happening with the currency. You've got capital accounts and goods accounts. And if a country is growing rapidly and people are anxious to participate in those financial markets, then the currency will appreciate as the current account deficit goes up. We've seen it time and again.

MR. HORIGUCHI: You know the U.S. economy would have been stronger had the dollar been weaker than what the--than the actual in the cost of the late 1990s.

MR. LACHMAN: Let me just take another three questions.

MR. HUTCHINS: Martin Hutchins, United Press International. I was fascinated by the analogy as the third bubble. When we had 1929 here, firstly the stock market dropped. And then it stabilized and then the economy dropped and then stabilized and then in May 31, the Credit Anstalt of Austria went bust, collapsed the world banking system and took us into the great depression.

So, my question is, given the problems in the Chinese banking system, is the Chinese banking system, today's Credit Anstalt?

[Laughter.]

MR. MAKIN: Even I'm not going to touch--I don't think it's a big enough issue, frankly. I really think that we're moving up to a point where there's a need for currency adjustment, there is some excess capacity. Getting on with it is not going to be the end of the world. And just before we do it as some of the speakers have reminded us, there's always a great deal of hand-wringing. An example of the U.K. in 1992; example of the U.K. in 1967, when it was thought it would be the end of the world if Sterling depreciated at that time.

It's not going to be the end of the world if the Chinese currency appreciates, we'll simply get prices and resources closer to equilibrium levels. Right now, they're moving out of equilibrium.

MR. EARP: My name is Richard Earp [ph], from the University of Montana. Do I get a question for every 500 miles driving out here? I'll just ask one question and I'll keep it brief. Yesterday, I read that Fitch, the [inaudible]-rating agency upgraded the rating for China. The more general question I have is why does money continue to flow into China, given the impending risks there, the impending crisis that may be building up in the domestic system? Are they hedging their position against a major credit crisis or even a broader economic crisis in China or, more generally, how are the private sector investors that are putting money in China, assessing that risk? They seem to be much more optimistic than most of the members of the panel?

MR. LACHMAN: John, I think that wasn't a Credit Anstalt type of question, would you like to answer it?

MR. MAKIN: Well, I think that the money that--a lot of the money that's going into China is to invest in real capital. We're not seeing a credit bubble that's being driven by foreigners, like the Asian Tiger's bubble. We're seeing a credit bubble that's being driven by chinese who are working and saving and investing, but the only place they can invest is in the domestic banking system.

So, it's a different, it's not as if investment bankers are pumping money into China. And that's part of the point. The vulnerable, the people who are vulnerable to a bubble bursting in China are the Chinese.

[Off microphone inaudible.]

MR. MAKIN: Well, if you have a plant in China--there's a difference between if you've invested in real estate in China or if you have a production facility, I suppose you are exposed to some extent, but if your only vehicle to save is a deposit in Chinese banks, you're much more vulnerable than if you're General Motors and you have a production facility in China and the currency moves up or down, you've got an issue. But it's not as compelling as it is if you're a Chinese investor.

MR. LACHMAN: I think I'm going to have to close this, but let me just take two or three questions at once and then give the panelists a last opportunity.

MR. QUITE: My name's David Quite [ph], my question's for Mr. Chen. I'm just wondering and Mr. Quarles, your point earlier about sort of the other issues other than currency and macroeconomic questions about WTO implementation which might have a much more profound effect on U.S./China trade relations. I'm must wondering what political capital do you blow forcing a debate on currency revaluations. Domestically, it's being driven predominantly by manufacturers who draw a straight line between 2.5 million job losses in the last two years and the Chinese currency which has been the same price for 10 years. How much political capital do you blow, particularly when China is sensitive to these issues about multilateral trade implementation and its currency values? And would those efforts be better focused on getting them to comply with intellectual property, customs issues, capital market development down the line.

MR. LACHMAN: Thank you.

PARTICIPANT: My question to Mr. Quarles. Would you please talk a little bit about joint technical cooperation program between U.S. Treasury and Bank of China, particularly on what will be done in this program? For example, does this program include some dialogue mechanism between the two parties, like, Yen/Dollar committee, by between Japan and the U.S. in the 1980s, which worked as a kind of a level to expedite a way to flexibility and opening up the capital account?

MR. LACHMAN: Last question back there.

MS. YUNG: Ann Yung [ph], from MTD TV, back here, when you answer my question please, use more institution and more common sense, because I'm afraid you're going to confuse my audience than make it clearer. Okay, so, my question is more appeal to the fundamental institution actually. I think the value of the currency fundamentally depends upon the level of confidence or how much optimistic the people who hold the currency have. I know I have lots of friends in China and I know that when they--I know that whenever they have a chance to convert the Renminbi to a dollar they will do so. So, after the float, do you think--well the Renminbi work out to be devalue or appreciate? The second question is, as Mr. Chen mentioned that in China's economy, there are lots of problem, such as the consumer side to every culture, those kinds of domestic problems.

I think for agriculture, for example, the farmers cannot let out their voice, when this problem, even though the problems are very severe. And in the case of the Renminbi currency value, however, the international community can let out some voice. So do you think this problem is actually an exporting of the domestic problem of China's fundamental economic structure, may be, in a way to use an international community.

MR. LACHMAN: Let me ask Mr. Chen just to handle the question on the WTO and the political capital.

MR. CHEN: I think to address the fundamental issue of global slowdown or excess capacity, in other words where excess capacity is sort of now spiraling off the price levels, driven by the competitive manufacturers in China and other countries.

I think a good thing to do is to help countries like China to build up their domestic demand. Now, so far, China has been doing that from the import side, you know, the absolute amount of importing fees in China is larger than the debt of the U.S., debt of the EU and that of the G-7 combined. So, in that sense it's making a contribution. But I don't think it's sustainable as Nick argued. This is driven more by the official directed investment, with which may generate bubbles. That's where I fear there might be bubbles, in real estate and also official directed project, like all those industrial zones, you know, high-tech zones, and all these concessions given to multinationals and they just put in money like crazy. The money all comes from the state banks.

So I think part is the trouble. But the consumer side has been very weak, so some kind of mechanism that will help the consumer side to increase the demand will be good, sustainable contribution to the world trade. And this could happen, for example, by implementing more--opening up more of the service sector to the world or the financial development with the sort of help of the international financial community.

For example, China has not credit cards to speak of. No, there are some in the name only, but they don't really borrow, they just pay within the grace period.

Now, if the savers are able to see the financial instrument that can actually channel their future income into current savings with no sort of worry, then they would increase the current consumption. So a simple thing that the financial industry can do to China will change the whole balance of this savings issue over savings. And that way we can created demand for world imports.

So, things like that can be sort of implemented under the [inaudible] agreement where China has agreed to open its financial sector within a few years. So, these kind of things and, perhaps, transparency for foreign service companies to go into China with more sort of ease would also help develop this private sector demand. I'm not so sure about the official side that keep the economy running which has a good fiscal side effect. But then the actual private consumption and the private sector production are something that needs to be addressed.

MR. LACHMAN: Just want to ask Mr. Quarles if you want to comment a bit on that cooperation issue or if there's anything to add and then I'll turn to Professor Meltzer just to make some concluding remarks.

MR. QUARLES: Sure, one--I guess just one sentence on the question of whether we're going to political capital first in the effort--in this effort, although my staff probably would have preferred me to dodge that bullet. But I actually don't think that we are. I mean, it's a perfectly reasonable question but I was certainly surprised at the degree to which the Chinese, while we were there, while we were there on the trip that was to discuss this issue and in the period since then--have, I mean, they have been engaged in this issue in a very encouraging way. Not treating it as sort of a salami slicing negotiation; how much do we need to give here or there, but, rather, and I think it was because of the way that we came and approached the issue with them. It was a very mature discussion, the points that Harvey Chen made about their clearly wanting to participate as mature players in the international system, focusing on, you know, the benefits to China and also the benefit to the international system, in which China wants to be a leader.

And that remains true for those other issues, as well. And if that's the way you approach this issue--you don't say, okay, if I've given you this, I don't have to give you the others things. It's--all of these issues have manifest benefits to China and to the world in which China wants to be a leader. And so, it's not in China's interest to treat one at the expense of the other. And, certainly, that's the way we perceived that they've been approaching the issue.

On the Technical Cooperation Agreement, there will be a dialogue mechanism, there will both be sort of a regular dialogue, as well as--and part of that dialogue will be to develop particular areas where the Chinese believe that some U.S. financial expertise can help them strengthen their market institutions and regulatory regimes, again, as a way of strengthening the environment in which a flexible currency would operation, like developing money-market instruments or indirect market instruments; developing regulatory regimes for foreign exchange derivatives; those sorts of technical issues. Part of which, you know, some of those questions can be dealt with in a regular dialogue. And some of them are dealt with in sort of more intensive interaction between technical experts.

MR. LACHMAN: Thank you very much.

MR. HORIGUCHI: --capitalists about this exchange-rate issue. I think the right place for that to be discussed with some kind of conclusive result is the IMF. I'm a little bit surprised with the [inaudible] reticence of IMF. It's not something that the bilateral pressure be placed in a most direct, visible way. I think [inaudible] for consultation are there precisely to debate and come to some kind of international and acceptable conclusions.

MR. LACHMAN: Thank you very, much. Professor Meltzer.

PROFESSOR. MELTZER: This is an excellent panel, so I have very little to do. The--I think most of the main points have been made and made well and in some cases made repeatedly.

There are a few things that I would like to add to the discussion and I won't try to summarize all.

My own view on this subject is to say that China should float, but liberalize gradually. And I think that there's a long history that says countries that liberalize quickly, often-especially with weak banking systems and unsophisticated financial markets, often run into trouble for themselves and, in China's case, for the rest of the world.

So, what will the Chinese do, I think the Chinese have already given a pretty clear indication of what they're going to do. They're not going to float the currency, they're going to gradually appreciate it and they're going to liberalize gradually, also.

And that's what they've been doing since, by my count, 1996, when they went to current account convertibility; in 1997 when they said that they would open their capital account fully by the year 2000, delayed that and since then have taken several modest steps, but all in the same direction and all suggesting that there are going to be more steps behind them.

So, in this discussion which took up a lot of the thing here, I think between those who think just liberalize and take off all the controls and those who say go slowly, I think the Chinese have given their answer, which is that they're going to go slowly.

Now, to put this--one subject which did not get much discussed here, a little bit--was, of course, this is the case of the seller saying to the or the buyer, sorry, saying to the seller, please raise the price, charge us more, right.

There are other things which would be helpful and which would be more of a win/win thing; some of them Mr. Chen talked about, such as opening their markets; doing more liberalizing their trade rules; allowing more U.S. banks to buy more of their financial assets. They moved from 15 to 25 percent ownership rules. But they could do more in that direction and that would be things--that would really be steps which would be in the interest of both China and the United States and would be win/win sorts of things. And while they wouldn't necessarily solve the capital accounts problem, they would certainly be steps which move in the right direction. And I hope that the U.S. government and others who are pressuring China would remember that the first best solution for both sides is not necessarily just limited from raising the price from sellers to the buyers.

Why do I think--one of the reasons why the Chinese are going to do what they're going to do is the reason that Nick Lardy emphasized so very well; namely, that they have a plan for the year of having 18 percent money supply growth, which would, by my calculations produce a little bit of inflation. And they're actually running 21.6 percent money growth from the year to August, which is more than they planned and which is going to give them a higher rate of inflation. And the Chinese have a long history of not liking inflation, at least since the time when we ruined their currency in the 1930s.

So my guess is that events are going to move them along at perhaps a faster clip than they might like because they're going to want to avoid the inflation problem which is building up there. And with that inflation problem, as Nick Lardy pointed out, they are expanding credit very rapidly, and a lot of that appears to be going into more bad loans.

So what is the bottom line from that? I then one point which was implicit in what many people said, but which needs to be made explicit is, the Chinese cannot avoid some revaluation to their real exchange rate. It's either going to happen because of inflation or it's going to happen because of appreciation. And it's probably going to happen both ways. That is they're going to get--the prices are going to go up because they're going to have an inflation and the prices are going to go up because they're going to slowly revalue. And tha