The US House of Representatives has just voted a bill allowing the US government to retaliate against China for manipulating its currency by implementing import tariffs.  It still requires Senate and Presidential approval to go into effect.  But this is a significant escalation of the dispute between Washington and Beijing.  Who is guilty?  What are the real issues?

Before we get started, why do they use two terms, Renminbi and yuan?  Renminbi literally means “the people’s currency”, and is usually abbreviated as ‘RMB’.  The principal unit of the Renminbi is the Yuan.  In reality, however, most people use the terms RMB or yuan interchangeably.

Is China a currency manipulator?

Currency manipulator is quite simply a horrible expression.  And the idea that the government of one country should call the Chinese manipulators is rather offensive. 

Sure, China is a currency manipulator if that means that it artificially fixes its exchange rate.  But China is not the only one.  Hong Kong has had its exchange rate fixed at 7.8 Hong Kong dollars to the US dollar since 1983.  Many other countries peg their currencies to the dollar, and some countries also maintain a fixed rate against the euro.

More generally, while some countries fix their exchange rate, other countries allow the value of their currency to be determined in the market, that is, floating currencies.  But even in the case of floating currencies, governments often intervene in the market to influence the value of the exchange rate.  For example, the Japanese government has been intervening by selling the yen to push down its value which it considers to be too high.  So we are all manipulators to some extent.

How is the Chinese currency “manipulated”?

For most of its history, the RMB has been pegged to the US dollar at a fixed exchange rate.  For period 1997 to 2005, Chinese government maintained a peg of 8.27 RMB per dollar. 

On 21 July 2005, the fixed peg was lifted, and the government managed a gradual revaluation of the RMB against the dollar, in fact 21 per cent over the three year period to 2008.  At the same time, however, the dollar entered into a steep decline against the euro, yen and other currencies which meant that China’s overall competitive advantage was mostly preserved.  Interestingly, while the Chinese exchange rate was being revalued, China’s current account surplus soared to almost $400 billion, more than 11 per cent of GDP in 2007.  Even in 2009, it remained above 5 per cent of GDP, almost $275 billion, and it is heading up again. 

In July 2008, when the global financial crisis struck, China repegged the RMB again.  Under immense pressure from the US, on 19 June 2010, the People’s Bank of China announced that it would lift the peg.  China has ruled out a large one-off revaluation.  Now the value of the RMB is managed against a basket of currencies, not just the dollar.  Since the peg was lifted again, the value of the RMB has risen less than 1 per cent.  Today, the US dollar is worth 6.70 RMB.   

Is the currency undervalued?

It is impossible to judge precisely whether a currency is undervalued or not.  At any point in time, most economists would say that many currencies are either under- or overvalued.  But as Fred Bergsten argues, the fact that the Chinese authorities buy about $1 billion daily in the foreign exchange markets to keep their currency from rising is pretty clear evidence that it is undervalued.  According to Bergsten, it is undervalued by about 25 per cent on a trade-weighted basis and by about 40 per cent against the dollar. 

But there are many other different estimates based on purchasing power parity and notions of a sensible current account balance.  Indeed, some people have much lower estimates of the extent of the RMB’s undervaluation.  One complicating factor is that Chinese capital outflows are restricted, and we do not know how much capital would flow out in a free market. 

The effect of the fixing of the Chinese RMB is amplified by the fact that Hong Kong, Malaysia, Singapore and Taiwan also manipulate their currencies by maintaining a close relationship to the Chinese exchange rate.  There are many other countries with large current account surpluses, like the big oil exporters, Germany and many other emerging economies, implying that their currencies are also undervalued.  China is not the only guilty party, but all the focus is all on China. 

China’s exchange rate undervaluation represents a subsidy on all exports and a tariff on all imports, and arguably is therefore a blatant form of protectionism.  Bergsten argues that China is creating lots of unemployment everywhere.  The undervaluation of the RMB is probably hurting emerging market and developing economies much more than the US because they are competitors of China in labor-intensive manufacturing production.

Would a revaluation of China’s exchange rate solve the global imbalances? 

The short answer is that we don’t know.  In the short run, it may have some effect.  Back in the 1980s, Japan was in the same situation as China today.  But the substantial appreciation of the yen after the Plaza Accord did not have a lasting impact on the global imbalances of the time.  Japan still has a large current account surplus today.

One important factor is that almost 60 per cent of Chinese exports are processed exports, being assembled from imported components.  If a revalued exchange reduces Chinese exports, it will also reduce imports of components.  This means that the overall effect on the current account may not be great.  In recent years processing trade has accounted for 100 per cent of the trade surplus 

Small gradual revaluations can also be offset by productivity improvements.  This is easy in China given that is in a phase of rapid economic catch-up, and is constantly upgrading its industry.  Also, profits can easily be squeezed, especially since multinational enterprises already have the large fixed, sunk costs in their supply chain infrastructure. 

An interesting case is the highly profitable US Apple which recently increased its processing fee to its outsourcing partner in China, Foxcomm, in response to recent deaths and industrial problems.  This is another way to compensate for exchange rate movements. 

If ever there were a big step revaluation of the RMB, China’s manufacturing production would like relocate to low-cost places like India and Vietnam, not the US.  Indeed, it is not clear that a sharp revaluation of the RMB would lead to an increase in US exports to China.  China needs high tech manufactured goods, and the US is not a major producer of these goods.           

There are many fundamental factors causing the current account imbalances on both sides.  The US has a big budget deficit, and low US private savings.  China has large corporate savings (as does Japan).  This excess savings hoarded by large Chinese state-owned enterprises should be distributed to the public as dividends, rather than being used for political patronage.  China also has high household savings in part because of weak social safety nets and rapidly ageing populations.        

The ultimate objective of the US is to reduce its current account deficit vis-à-vis China, not revalue the RMB per se.  Pushing China to stimulate domestic demand, and therefore imports, would be more effective.  It would also be more effective to try to get better market better to the service sector and public procurement market.  The US could also try to influence another factor behind the high Chinese corporate savings, namely the subsidized prices for land, energy and other inputs which give the corporate sector an artificial competitive advantage.  

What are the risks of US retaliatory measures?

The US could retaliate by providing a countervailing subsidy to US production or imposing a unilateral tariff on Chinese imports.  Paul Krugman recently proposed a 25 per cent tariff. 

While this could lead to a dramatic drop in US imports from China, many people would be hurt.  Nearly 60 per cent of Chinese exports (mainly processing exports) come from foreign multinational enterprises (some American), not Chinese enterprises, who would be adversely affected.  The countries and companies supplying the components for these processing exports would also be affected.  US importers like Walmart would be hard hit, and US consumers would also lose out.  The Chinese government could retaliate by putting tariffs on US imports -- China is the US's 3rd most important export destination after Canada and Mexico.  It could also respond by making life even more difficult for the many American companies operating in China.  Lasty, it could accelerate its foreign reserve diversification out of US dollars.   

Could a revaluation of China’s exchange rate be beneficial to China?

As countries develop over time, it is natural for their real exchange rate to appreciate reflecting productivity growth in the tradable sector.  A higher exchange rate provides benefits to all consumers by reducing the price of imports. 

China’s current account surplus also means that it has accumulated vast amounts of foreign exchange reserves.  It now has more than $2 trillion, with much of this in US dollars, and with a low rate of return.  Further, the value of these reserves will fall if the dollar depreciates.  This massive reserve accumulation is arguably a waste of money, even though some reserves are useful for China's international diplomacy like the recent assistance to Greece.  It would probably be better to invest this money at home or consume it.  One major problem of China’s fixed exchange rate is that its resultant current account surplus adds to the domestic money supply and contributes to inflation, which indirectly raises the real exchange rate anyway.

Why does China not revalue the RMB?

Many people cannot understand why China does not make a big revaluation of the RMB.  After all, employment in export industries only accounts for around 5 to 6 per cent of total employment.  And as McKinsey has calculated, when you take account of all the imported parts and components, the contribution of exports to Chinese GDP is not so high.

However, Chinese state power has more limitations than many imagine.  The government does not have total power and authority.  China is becoming an increasingly diverse and complex society with different interest groups.  The vast majority of China’s exports are produced in just eight coastal provinces.  Powerful economic and political interest groups in these provinces lobby against revaluing the exchange rate.  Many of those making handsome profits from exporting have close relations with local party and state officials.   

More generally, China is besieged with conspiracy theories.  Many Chinese believe that the US undermined and brought down the USSR.  They believe that the US did the same thing to Japan by pushing it to revalue the yen in 1985 Plaza Accord, and pushing it into economic crisis.  In reality, Japan’s lost decades were caused by a self-inflicted bubble economy, reckless bank lending and many policy failures.

But this Chinese paranoia is so great that the harder the US pushes China to revalue the RMB, the more resistant it becomes.  The Chinese see this as a question of sovereignty. 

So, where are we?  Stalemate!  Let’s hope that there will not be any political accidents.

References:

The US-Sino Currency Dispute: New Insights from Economics, Politics, and Law, Simon J Evenett, 15 April 2010

http://www.voxeu.org/index.php?q=node/4868

A truer picture of China’s export machine, McKinsey Quarterly, September 2010.  www.mckinseyquarterly.com