Bridges Weekly Trade News Digest • Volume 14 • Number 7 • 24th February 2010
The US and China: Trade and Currency in the Balance
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Cavernous trade deficits and high unemployment are an unhappy combination, for governments and for open trade.
When unemployment rates are high, as they are now - around 10 percent in the United States, and higher in some parts of Europe - politicians wishing not to join the ranks of the jobless find it harder to argue that what domestic demand there is should support jobs elsewhere.
Thus, when times are good, deep trade deficits - and their inevitable counterpart, large surpluses in other countries - tend to be the subject of largely ignored warnings about global imbalances. But during recessions, they become politically explosive.
During the early 1980s, trade tensions pitted the United States against Japan and Germany, both of which were running substantial trade surpluses with the US. Today, it is the US and China, a relatively new export powerhouse, that have come to epitomise global financial imbalances (though they are hardly the only countries with significant surpluses or deficits).
A country’s balance of trade depends on a wide range of factors, such as domestic savings and investment. But in times of crisis, countries with deficits seeking a quick fix for imbalances often single out exchange rates as the main culprit. Key surplus countries’ currencies are too weak, they argue, making their exports unfairly cheap and imports unduly expensive.
In the first half of the 1980s, Washington pushed for the revaluation of the yen and the deutsche mark. Today, it is the Chinese renminbi that stands accused of being artificially weak.
Part of the contention over China’s exchange rate arises from the fact that its currency has been effectively re-pegged to the dollar since July 2008, making it the only major economy without a floating exchange rate.
American and European policymakers have been urging China to increase the value of the renminbi (the base unit of which is called the yuan), but Beijing has rebuffed these demands. The tone of the exchanges has grown sharper. Earlier this month, President Barack Obama said that Washington would exert “constant pressure” on China, arguing that exchange rates were putting the United States at “a huge competitive disadvantage.” Chinese foreign ministry spokesperson Ma Zhaoxu hit back immediately, saying the renminbi had “drawn close to a reasonable and balanced level.”
“China has never attempted to seek a trade surplus,” he said, according to a report in the state-owned China Daily. “Accusations and pressure will not bring solutions.”
Few rules govern exchange rates
Despite their significant effects on trade competitiveness, exchange rates are not subject to any serious regulation at the international level. (A statute imposed by the International Monetary Fund statute has proven toothless.)
Nevertheless, changes in the value of a country’s currency vis-a-vis those of its trading partners directly affect the cost of imports and exports, and swings in currency values can be dramatic. What’s more, governments - depending on their wherewithal to do so - can exert substantial influence over their countries’ exchange rate through monetary policy and active intervention in financial markets. Generally, monetary authorities vary these policies in order to pursue an optimal balance among considerations like unemployment, inflation, and asset prices. But they can also use these tools to keep currency values at levels different from those that would ordinarily have been set by the market.
The WTO sets out rules - some strong, some weak - for many import-restricting policies: old-fashioned tariff increases, complex new technical requirements, remedies to offset alleged underpricing or subsidisation, and ‘buy domestic’ clauses in government procurement contracts. It also prohibits several kinds of subsidies that governments might use to try to boost exports.
An undervalued exchange rate, however, works as both an import tariff and an export subsidy. But the only provision in WTO rules dealing with them is a clause specifying that members “shall not, by exchange action, frustrate the intent of the provisions” of the General Agreement on Tariffs and Trade (GATT Article XV(4)). Some experts think this wording is too vague to be the basis for an unequivocal legal victory in a dispute at the global trade body.
The debate over China’s currency has been taking place against the backdrop of the unravelling of a pattern that characterised the global economy in the years prior to the financial crisis: overconsumption in the United States facilitated by borrowing from East Asia (above all, China), where saving vastly exceeded consumption.
This deep interconnection, dubbed ‘Chimerica’ by the historian Niall Ferguson, saw the Chinese save while the Americans spent. Cheap Chinese imports kept US inflation low while generating jobs in China, and Chinese savings kept US interest rates low (too low, say economists who believe that China’s surpluses help fuel the US’s asset price bubble). Now, with US households increasing saving and decreasing consumption, the US government is hoping to make up the difference by increasing exports - especially to fast-growing countries like China.
Is the yuan undervalued?
Critics of China’s exchange rate policy note that China, a rapidly growing economy with an enormous current account surplus, should ordinarily have seen its currency rise. Instead, the currency has stayed put a roughly 6.83 yuan to the dollar over the past year and a half. And as the dollar fell against other major currencies last year, the yuan fell with it, losing over 10 percent against the euro in the last ten months of 2009.
Estimates of the undervaluation vary wildly, from a few percentage points to as much as 50 percent. John Williamson and William Cline, economists affiliated with the Peterson Institute for International Economics, estimate that as of December 2009, China’s currency needed to appreciate by 40.7 percent against the dollar. They reckon that in March 2009, the yuan needed to appreciate by 21.2 percent on average against all other major currencies; instead, by November of that year, its real exchange rate had decreased by 8.4 percent.
The Chinese government rejects these views. It notes that the renminbi appreciated by over 20 percent between 2005 and mid-2008 (a figure that, incidentally, is not very different from the 27.5 percent tariff that some US senators threatened China with in 2004 if it did not let the yuan rise). Beijing also resents the suggestion that it is not doing its part to contribute to global economic rebalancing, pointing to its 4 trillion yuan (US$586 billion) fiscal stimulus package.
Also, the peg cut both ways: when the dollar rose, as it did in late 2008 and early 2009 when investors fleeing financial market turmoil sought a safe haven in the US currency, so did the yuan, while other currencies fell. Between the start of 2008 and the end of 2009, the yuan rose against every major currency but the yen.
Jim O’Neill, chief economist at Goldman Sachs, wrote on a blog on the Financial Times’ website last December that according to the bank’s model for estimating fair value for different currencies, it was “no longer so clear” that the yuan was undervalued. He also noted that China’s current account surplus had shrunk almost by half, with imports growing more rapidly than exports, while domestic consumption growth remained strong.
“It’s very difficult to estimate the right exchange rate, that’s something we should never forget,” said Patrick Messerlin, an economics professor at the Institut d’Études Politiques in Paris and director of the Groupe d’Économie Mondiale.
“We have to be very cautious” when making such evaluations, he told Bridges. Nevertheless, a look at China’s domestic conditions, notably its large current account surplus, suggests that its currency was likely somewhat undervalued. China’s exchange rate policy was being affected by tensions between different domestic interest groups, Messerlin suggested. The bulk of China’s exports, at least for the time being, are relatively unsophisticated products manufactured in coastal states. These products are easily replaceable, and thus their makers would likely be hurt by a rise in the yuan.
What revaluation would - and wouldn’t - do
Furthermore, a revaluation of the yuan may not deliver everything expected by those who support it. Following the Plaza Accord in 1985, both the deutsche mark and the yen rose sharply against the dollar. But while the US trade deficit with West Germany shrank, its deficit vis-à-vis Japan continued to grow.
A rise in the yuan could have unintended consequences, according to Dani Rodrik, a professor of political economy at Harvard’s Kennedy School of Government. Undervalued exchange rates can contribute to growth in developing countries, he says, because they serve as incentives to shift economic activity into the production of tradable products, which tend to be produced by more modern, higher-productivity sectors. Rodrik estimates that a 25 percent appreciation in the yuan would reduce growth rates in China - the “the most potent poverty reduction engine the world has ever known” - by 2.15 percentage points per year. That would push growth below the 8 percent threshold the Chinese government deems necessary to maintain social peace.
However, the status quo has its own implications for development, argues Arvind Subramanian, a senior fellow at the Peterson Institute and the Center for Global Development. Subramanian says that China has effectively been hogging the world’s production of tradables. “Higher tradable goods production in China results in lower traded goods production elsewhere in the developing world, entailing a growth cost for these countries,” he wrote this month in the Financial Times.
In that article, Subramanian contended that viewing China’s exchange rate policy through the prism of global economic imbalances missed the point. “The real victims of this policy,” he wrote, “are other emerging market and developing countries.” These countries compete more closely with China than the US or the EU, which have different comparative advantages.
Countries that depend heavily on exports of light goods have indeed been affected by the value of the yuan, said Ed Gresser, a trade expert at the Democratic Leadership Council, a centrist Democratic Party think tank in Washington. While China’s exchange rate policies might have hurt clothing exports to the US from Central America or Cambodia, he noted, countries selling commodities denominated in dollars “might not mind.”
This difference is also being played out within individual countries, leading to shifts within the economy, Gresser observed to Bridges in an interview. Thailand, for example, was being pushed out of the US market for toys, consumer electronics, and clothes. On the other hand, Chinese demand has created “a huge boom” in rubber, tin, and agricultural commodities.
The tension between the diminished growth potential for other developing countries and the risks to Chinese growth pose “a significant challenge,” acknowledged Eswar Prasad, a Cornell University professor and former head of the IMF’s China division.
Hopes that domestic consumption would quickly supplant exports as a principal driver of Chinese growth were likely to be disappointed, he said. “It is difficult to see how China could use up all the capacity it has built up through the giant investment boom without relying on exports,” Prasad told Bridges. “China is going to become even more dependent on exports in the near future.”
Given these circumstances, Prasad thought that Beijing would only alter its exchange rate policy if the dollar fell significantly, or if foreign export markets were very strong.
Extremely low interest rates in the US, part of a loose monetary policy aimed at stimulating economic growth, present developing countries with floating exchange rates with additional complications. “Emerging economies are being squeezed between low interest rates in the US and the fixed Chinese exchange rate,” Prasad said. Capital is flowing into emerging economies, as investors search for higher returns. This is driving up their currencies, in turn exacerbating their competitiveness concerns vis-a-vis China.
Many economists argue that allowing the yuan to appreciate would have considerable benefits for both China and Chinese consumers. A growth model that strikes a better balance between domestic consumption, investment, and exports would be more sustainable. Consumers would see their purchasing power rise. The government has lowered the cost of ‘sterilising’ capital inflows to prevent the currency from appreciating by engaging in financial repression, part of which involved keeping interest rates on bank deposits extremely low. Households would benefit from higher interest rates on their savings, which represent a considerable portion of their income. At the international level, a less heavily managed yuan could play a greater role in global finance.
Some financial market analysts have started to see signals that Beijing may let its currency rise - not because of hectoring by Washington, but because of a reassessment of the country’s interests.
O’Neill of Goldman Sachs said this month that China may allow the yuan to appreciate by as much as 5 percent in an attempt to prevent the economy from overheating.
“I have a strong opinion that they’re close to moving the exchange rate,” O’Neill told Bloomberg in a telephone interview on 12 February. “Something’s brewing. It could happen anytime.”
ICTSD reporting.
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