Chinese Currency Policy: No Easy Answers

Click here for a printer-friendly version of this article

By April 15, the Treasury was supposed to report to Congress on “whether any foreign economy manipulates its exchange rate vis à vis the US dollar to prevent effective balance of payments adjustments or to gain unfair competitive advantage in international trade.” While everyone has been focused on whether China will be labeled a currency manipulator under this definition, the Obama Administration just announced their plan to defer this decision until well after the Chinese President, Hu Jintao, visits Washington for a nuclear proliferation summit later this month. Despite this delay, let’s review some of the facts surrounding this debate.

There is no question that China’s exchange rate policy meets this description. It is less clear that such a public rebuke of China is in the long-term interests of the US. However, whether the Treasury labels China a currency manipulator or not, it is clear that the old arguments against tough action no longer apply.

According to the International Monetary Fund (IMF), the purchasing power of the Yuan Renminbi (CNY) is equal to 3.798 for every dollar. However, since 2008 the CNY has been pegged at 6.83 to the dollar. Hence, the CNY is about 44% undervalued on a purchasing power parity basis. When The Economist recently updated its “Big Mac index” it also found the CNY was substantially undervalued.

Using the Big Mac as an example, if a US citizen were to take the $3.54 it costs to buy a Big Mac and convert it into renminbi, he would have just over 24 CNY. But this is nearly twice the 12.5 CNY it costs to purchase a Big Mac in China. Thus, the currency is undervalued in that the rate of exchange is far below the ratio of prices for equivalent consumer goods. This has the effect of depressing input costs given the relationship between competitive wage rates and the domestic price level. If we assume a manufacturer of a globally traded product has to pay his worker the equivalent of three Big Macs an hour, the cost of an hour of labor would be the equivalent of $5.50 in China and $10.62 in the US. This makes the goods produced in China less expensive to Americans and the goods produced in the US more expensive for Chinese.

A revaluation is not required to bring these costs in line. Changes in the domestic price level – i.e., inflation differentials – can have the same impact. But when the discrepancy is as large as it appears to be here, the required rise in inflation would likely be more disruptive than a one-off revaluation. For example, in order to close a 40% gap in five years Chinese inflation would need to exceed US inflation by 10.8% per year; closing the gap in 10 years would require Chinese inflation to exceed US inflation by 5.2% per year. While this heuristic leaves aside key issues like terms of trade and productivity differentials, it illustrates the basic mechanism by which an undervalued currency impacts competiveness and trade dynamics. (Inflation differentials are also what explain why Greece, which has had high inflation, has become uncompetitive relative to Germany, which has had low inflation, even as the two countries share the same currency).

China is able to maintain its peg to the dollar through currency controls that limit the renminbi’s convertibility and by printing CNY to purchase dollars. The volume of dollars the People’s Bank of China (PBC) must purchase are a function of both the trade surplus and the inflows of portfolio investment into China. According to the IMF, China’s current account (trade plus investment income) surplus has averaged 9.5% of GDP from 2005-2009, a record for any economy of China’s size. In addition to the hundreds of billions of foreign exchange generated from such a large trade surplus, China accumulates foreign exchange when the renminbi it provides to “qualified investors” to acquire Chinese securities exceeds investment outflows.

At the end of December 2009, China’s State Administration of Foreign Exchange (SAFE) held $2.4 trillion in foreign exchange reserves. China’s state banks and the China Investment Corporation (CIC), China’s sovereign wealth fund, are thought to hold $200 billion more in external assets. No one knows what portion of this portfolio is dollar denominated. A reasonable estimate is 65%, according to the Council on Foreign Relations, which means China controls roughly $1.7 trillion in dollar-denominated assets. CFR scholars estimate that China lent an astonishing $400 billion to the US in 2008 alone.

The scale of China’s foreign exchange intervention and its obvious impact on the global trade balance seems like an open-and-shut case. However, defenders of a laissez-faire approach to China’s currency policy generally make three compelling arguments:

(1) The Japanese Yen appreciated from 360 to the dollar to 80 to the dollar over a twenty year period during which time the Japanese trade surplus rose by 4% of GDP. Anyone expecting a renminbi appreciation to magically solve the trade imbalance is deluding themselves. The underlying dynamics are driven by savings and investment imbalances, not relative prices. Until Chinese savings and US consumption drop in tandem, the imbalance will remain.

(2) The lack of a modern financial system means that China does not have the capacity to intermediate the enormous cross-border financial flows generated by its open economy. There is no developed international market for renminbi borrowing and lending, and the domestic Chinese institutions could not possibly hold sufficient dollar assets to provide a stable exchange rate because all of their liabilities are denominated in renminbi. The choice is not between a peg and a free float, but between a peg and chaos.

(3) The US derives substantial benefits from the arrangement that should not be taken for granted. The nearly $2 trillion of dollar obligations accumulated by China have reduced US interest rates and increased credit availability. In addition, the managed exchange rate increases US households’ purchasing power by allowing the US to import low-cost goods. Since the US dollar is not backed by anything other than the public’s willingness to accept it to settle debts, how could the US be the loser in an exchange where they receive trillions in low-cost consumer goods in exchange for paper?

If the Chinese currency policy helps to foster international economic stability and delivers immense benefits to the US, then it would be a dreadful idea to demand changes that would also likely trigger a trade war. This view has essentially been US policy for the past several years: don’t make ostentatious demands; ensure Chinese officials appreciate that the current course is neither politically nor economically sustainable; work with China to develop the social safety net to encourage domestic consumption and reduce savings; and build more robust financial institutions with a long-run goal of a freely floating currency.

But while this sensible policy was being pursued, a global financial crisis threatened the solvency of America’s banking system and resulted in the sharpest decline in output since World War II. At the center of the crisis was a credit bubble that impacted nearly all leveraged asset classes, but most particularly residential housing. And, as Federal Reserve Chairman Bernanke has argued, at the center of this bubble was a current account deficit that was the mirror image of the Chinese surplus. The dollars reinvested by the Chinese in Treasury bonds, and in Fannie and Freddie debt and mortgages, helped to suppress interest rates and boost housing prices. This fed a destructive cycle and resulted in enormous “maldistributions” of leveraged investment into an asset (residential housing) that does not increase wealth, boost productivity, or increase standards of living.

The arguments against punishing China retain their validity, but are now offset by a much deeper reality: a political body’s market interventions on the scale of the Chinese government distorts prices and market processes in ways that are difficult to understand, and even harder to predict. Whether or not Treasury labels China a currency manipulator, it is clear that the US can no longer afford the old policy of gradual liberalization. Too much has been learned about the destructive consequences of global imbalances to continue on the same path.

It is vitally important that Chinese policymakers come to recognize that the long-term costs of these imbalances far outweigh the short-term benefits. The Chinese leadership’s central concern has been that premature currency appreciation would dampen growth. According to one estimate, from Harvard Kennedy School economist Dani Rodrik, a 25% devaluation would reduce growth by 2.15% points. Given that China has committed vast resources to meeting its unofficial target of 8% growth per annum, a target that is seen as essential to maintaining social stability and political control, this isn’t likely, at least not in the short term. There have been some encouraging signs, however. Recently, Zhou Xiaochuan, China's central bank governor, suggested that the unofficial peg was a transitional measure designed to help China weather recent economic turbulence. Yet Mr. Zhou also warned against "premature withdrawal of stimulus policies," including, one presumes, the weak RMB. And for the moment, US policymakers have very little leverage over their Chinese counterparts.