China's new exchange rate policy: will China follow Japan into a liquidity trap?

This article by Prof. Ronald I. McKinnon, William D. Eberle Professor of International Economics at Stanford University, was first published in the Economist's Voice, Volume 3 (2006) no. 5. It finds that the recent abandonment of China's "traditional parity" of 8.28 yuan per dollar makes a new credibly fixed exchange rate strategy more difficult - and certainly not possible for some time. It argues that the second-best solution is for China to continue, and possibly strengthen, its foreign exchange restrictions on liquid financial inflows, thus limiting the foreign pressure to drive interest rates down.