Why China and India should float their currencies to be long term competitive

China and India still manage their currency pegs in an apparent attempt to make the countries more competitive. This assumes two things: (a) A few people in each country know what the optimal exchange rates are and (b) by keeping such an exchange rate, they can strategically engineer the country to be more competitive. Both of these ideas are false.

First, by maintaining an artificial exchange rate,  both countries are propping up industries such as commodity manufacturing (in China) and commodity services (in India) behind an unsustainable labor cost advantage. These artificial currency regimes create inefficient allocation of capital (by the private sector and the government) as well as human resources (by individuals electing to follow certain education and career paths). If the explosion in employment in these industries was largely driven by labor arbitrage, masses of population will be unemployed and unable to transition to other industries in the future when such an arbitrage ceases to exist. This is a catch 22 for policy makers as by holding the tiger by its tail (by keeping artificially low exchange rates), they have gotten into a situation that they cannot let the tail go (as it will create significant immediate unemployment and social unrest). This is a good lesson for future policy makers.

It is probably better for both China and India to take the short term pain (rise in unemployment and slower growth) for long term gain. A floating currency will force companies to compete directly based on skills and innovation (rather than artificial low cost). This will result in a more optimal allocation of capital and human resources into different segments. If China and India really want to be long term competitive economies, there is no other way than having free floating currencies and joining the international economic society, unhindered.

Finally, the idea that few government bureaucrats can strategically engineer optimum long term growth by managing currency rates is preposterous.