Published Articles

The Domestic Political Sources and Consequences of the Chinese Government’s Decision to Maintain a Weak Currency

March 4th, 2011 by Gonzalo E. Vazquez

Today we understand that a large component of our economic life is shaped by global, rather than national (much less local), economic forces. Global economic exchange has highlighted the enduring political battle between the winners and the losers in this competition that has a direct effect in raising the income of some people and lowering the income of others. The effects of the distribution that occurs as global economic exchange guarantee economic competition among nations. To expand and consolidate their gains, the winners try to seek a deeper relationship with the global economy, while the losers try to minimize or reverse their loses by building walls between global and national economies.

In this paper, I will try to explain China’s current account imbalances due to exchange-rate policies. I will analyze the alternative of the revaluation of the yuan to level the current account imbalances and finally, evaluate the need for internal reforms in China in strategic sectors. These reforms would encourage domestic consumption, which will allow China to achieve the economic objectives it has long searched for, such as a solid financial sector, internal macroeconomic stability, open market access for its exports, and a healthy, sustainable rate of economic growth.

Many economists have argued that the Renmimbi (also called the yuan) is undervalued against the U.S. dollar and that China’s exchange-rate policy intentionally retains this undervaluation to promote its exports. Such concerns prompted Congress to pressure first the Bush administration and now the Obama administration to urge the Chinese government to revalue the yuan and to threaten to impose tariffs on imports from China if it doesn’t.

Efforts to pressure China to revalue its currency come in the broader context of global current account imbalances. According to Goldstein , China’s exchange rate policy is not simply a reflection of scapegoating, policy failures, and a lack of strategic planning outside of China. China’s exchange rate policy itself is seriously flawed, given its current macroeconomic circumstances and its longer-term policy objectives.

Because China pegs its currency to the dollar at an undervalued rate, it reduces the price of China-made products in the U.S. market and raises the price of American products in the Chinese market. Consequently, demand for Chinese goods rises while demand for American goods falls. Yuan revaluation would reverse these relative prices, leading to greater demand for American goods, falling demand for Chinese goods, and an adjustment of the trade imbalance.

Analysts argue that the global current account imbalances that are the consequence of Chinese exchange rate policies pose a serious threat to global economic stability. Adjustment of these imbalances requires exchange-rate realignments wherein the yuan is revalued by as much as 40% against the dollar.

It is not clear that a modest revaluation will cure all ills. Studies show that a more substantial Renmimbi (RMB) revaluation of between 15% and 30% is needed to rebalance the balance of payments, that is, the situation in which the capital account balance offsets the current account balance so as to keep international reserves stable. In this context, it is likely that a modest revaluation will be seen as the forerunner for further adjustments during the quarters to come, which will just encourage speculation on the RMB and stimulate the inflow of private capital.

Other observers analyze contemporary global imbalances through an economic model that emphasizes cross-national differences in savings and investment rates rather than exchange rates. Within this framework, the U.S. current account deficit is a consequence of a very low national savings rate relative to investment. For the past few years, the U.S. savings rate has been close to zero. In contrast, China’s current account surplus is a consequence of a very high national savings rate relative to its investment. Indeed, in China the savings rate was almost 50% of national income in 2008. These observers suggest that Americans must consume less and save more and the Chinese must consume more and save less.

It is understood that China has blocked any significant rise in the yuan by intervening massively in the foreign exchange markets. By keeping its own currency undervalued, China has also deterred a number of other Asian countries from letting their currencies rise very much against the dollar, for fear of losing their competitive position against China.

China has recently let the yuan rise marginally against the dollar. China continues to link its exchange rate to the dollar and the dollar has fallen against virtually all other currencies. The world’s most competitive economy has become even more competitive through a deliberate policy of currency undervaluation and this is definitely a positive situation for China.

All of these exchange-rate issues have given China another advantage. About one quarter of all China’s economic growth in the past two years has stemmed from the continued sharp rise in its trade surplus. China is thus overtly exporting unemployment to other countries and apparently sees its currency undervaluation as an off-budget export and job subsidy that has avoided effective international sanctions.

This situation will put the U.S. and other developed countries in a losing position because global imbalances represent the single largest threat to their continued growth and stability.

Focusing on the exchange rate as the solution to the problem is unwise because a devaluation of the yuan would do little to correct the imbalance while it would certainly create a backlash in China. Instead, some analysts advocate a broader range of reforms designed to integrate China more firmly into the global economy. Is understood that China must initiate important reforms internally, such as changing its tax system, restructuring its corporate and banking sectors, and encouraging consumption.

The U.S. should take the lead in addressing the imbalances by developing a credible program to convert its present budget deficits into modest surpluses such as those that were achieved in 1998-2001. Obviously this could have a political cost to the U.S., as we have seen lately with the issue to approve the U.S. government’s budget for 2011.

China needs to adopt policies to promote an opposite adjustment, reducing its uniquely high national savings rate by increasing domestic consumption. China can increase domestic spending directly through higher government expenditure on health care, pensions and education. On the other hand, in the short run this will generate negative effects internally because of the inflationary pressures that will affect, among other things, the purchasing power of the yuan compared with other international currencies.

The Europeans have an especially large incentive to join the U.S. in such an initiative because their own currencies will rise much more sharply when the dollar experiences its next large decline if China and the other Asian countries each continue to block their own currency’s adjustment.

Closing Remarks
In economies that are open to international capital flows and foreign trade, exchange rates should line up so that, on average, country A’s currency has the same purchasing power over a representative basket of goods and services as that of country B.

However, in poor countries with low wages, the prices of non-tradable goods and services, such as haircuts, are much lower than the prices of non-tradable goods and services in wealthy (high wage) countries, even though the prices of highly tradable goods such as textiles and automobiles are similar. So one dollar (hard currency) will have greater purchasing power in a poor country.

China may not change its exchange-rate policies simply because other countries are urging it to do so. But, by the same token, the fact that there are many eternal recommendations for a revaluation of the RMB is not sufficient reason for rejecting that policy option if it is the best one available.

The main reason for revaluing the RMB by an appropriate amount is that it increases the odds that China will be able to achieve, as mentioned before, the economic objectives it has long pursued, namely, domestic financial reform, domestic macroeconomic stability, open market access for its exports, and a healthy, sustainable rate of economic growth. One cannot rule out the possibility that China will be able to rein in excessive bank lending and rising inflationary pressures without exchange rate action by implementing administrative controls and by increasing domestic interest rates. However, the effectiveness of administrative controls over the medium term is uncertain, and higher domestic interest rates may attract further capital inflows. If these measures do not do the job, imbalances will eventually grow in size, and there will be a need for more draconian policy adjustments thereafter.

Exchange rate action differs from other policy measures in one crucial respect: it addresses simultaneously internal balance (overheating and inflationary pressures) and external balance (the surplus in the balance of payments). The cost of a hard landing is too high to rely on half measures.

Some experts claim that China’s decisions on its future currency regime should pay primary attention to China’s own circumstances, not to one-size-fits-all prescriptions. Given the fragile state of China’s banking system, the capital-account decision should be delinked from the currency regime decision. All things considered, a two-stage currency reform is better than the alternatives because it reduces China’s current internal and external imbalances, it promotes the right sequencing of reforms within China, it contributes to the timely correction of payments imbalances abroad, and it moves monetary policy independence and capital-account liberalization in the desired direction in the long term.

Ending China-bashing once and for all is more than just a political issue. In both the United States and Europe, economists and the politicians they indoctrinate must discard the false theory that one can use changes in the exchange rate to control the net trade balance in a predictable way.

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