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Dr. Steve H. Hanke is a Professor of Applied Economics and Co-Director of the Institute for Applied Economics and the Study of Business Enterprise at the Johns Hopkins University in Baltimore.

Oct 21, 2010 (LBO) - A sudden appreciation of the Chinese currency, which is sought by the US, could disrupt China's economy and the world, rather than increasing the demand for American exports, a top monetary economist has warned.

"[I]f Beijing caves into Washington's current demands for a renminbi appreciation, the result is totally predictable," Steven Hanke, professor of Applied Economics at The Johns Hopkins University in Baltimore wrote in Indonesia based Globe Asia magazine. 

"A Chinese upheaval and a world disaster will ensue."

Hanke said there is a historical example of US having disrupted China's currency with disastrous results.

The First Currency War

China was on a silver standard when the rest of the world was on a gold standard at the start of the Great Depression. The exchange rate between the two countries was set by the relative price of gold to silver.

Then US president Franklin D Roosevelt had embarked of a Chinese currency policy.

"It was wrapped in the guise of doing something to help U.S. silver producers and, of course, the Chinese," Hanke wrote.

"Using the authority granted by the Thomas Amendment of 1933 and the Silver Purchase Act of 1934, the Roosevelt Administration bought silver.
"This, in addition to bullish rumors about U.S. silver policies, helped push the price of silver up by 128 percent (calculated as an annual average) in the 1932-35 period."

It was argued that a stronger exchange rate would increase the purchasing power of the Chinese which would increase the demand for US exports.

In the 1932-34 period, China’s gross domestic product had fallen by 26 percent and wholesale prices in the capital city, Nanjing, had fallend by 20 percent.

After failing to persuade Washington to stop pushing up Silver prices China had abandoned the Silver standard.

"This spelled the beginning of the end for Chiang Kai-shek’s Nationalist government. America’s "plan" worked like a charm – Chinese monetary chaos ensued," Hanke wrote.

"This gave the communists an opening that they exploited - one that contributed mightily to their overthrow of the Nationalists."

Pegged Regime

After Deng Xiaoping's reforms in 1978 the Chinese currency had experimented with several exchange rate regimes. Until 1994 the Chinese currency had depreciated steadily against the US dollar.

But from 1994 after inflation hit 24 percent China had started to firmly peg the currency to the US dollar.

"In consequence, the volatility of China’s GDP and inflation rate declined, and with the renminbi firmly anchored to the U.S. dollar, China’s inflation rates began to shadow those in America," Hanke wrote.

"Then, China entered a gradual renminbi appreciation phase (when the RMB/ USD rate declined in the 2005-08 period).

"Without a firm dollar anchor, China’s inflation rate picked up, relative to the U.S. inflation rate.

"And, yes, the volatility of China’s GDP picked up and China’s average inflation rate rose, too."

Hanke has previously pointed out that the US had pushed Japan to appreciate the Yen from around 350 yen to the US dollar to less than a 100 but trade deficit had not disappeared.

This is because trade deficits are not caused by exchange rates but savings behavior including capital flows. China 'imports' Treasury bills generated by a US budget deficit.

Other analysts have also pointed to 1994 budget law reforms which allowed China to firmly peg the currency which ended central bank financing especially of loss making enterprises.