The US dollar is falling again – this time sharply against other major currencies including the euro, yen and Swiss franc. In response to a deepening US subprime mortgage crisis, the US Federal Reserve has cut interest rates decisively and sharply, and continues to pump dollar liquidity into the global financial system. Meanwhile China’s renminbi (RMB) has been rising faster against the dollar in recent months, but it has been falling against euro and other currencies because dollar devaluation has been faster still. The result has increased political pressure for and market speculation about RMB revaluation.
Against this backdrop, many analysts and financiers continue to sound the alarm on China’s policy of gradual, small-step currency revaluation. They point out – validly and convincingly – that such a policy is costly for China itself for a number of reasons.
First, increased market speculation for RMB revaluation leads to more financial inflows into China and leads to excess liquidity: in January and February alone, China’s official foreign exchange reserves grew by $120 billion.
Second, while inflation is on the rise, a large revaluation would be helpful to lower the price on import goods.
Third, growing protectionism against Chinese exports (or possible sanctions on China for alleged manipulation of its exchange rate), means China would gain less from its undervalued currency.
Finally, structural distortions caused by repressed interest rates and an undervalued currency could also lead to economic, financial and social problems. According to this logic, China should implement a one-off jump to the equilibrium exchange rate.
What equilibrium?
But the first question to ask is simply: where exactly should the RMB exchange rate jump to? Moreover, who knows where the equilibrium exchange rate lies and how long that equilibrium – if found – could be sustained, given the rapid descent of the US dollar and the uncertainty surrounding US financial markets?
With ever more disclosures of unprecedented losses on the balance sheets of leading financial institutions, and given an on-going credit crunch across international markets which has seen the Fed aggressively pump USD liquidity into the global financial system, it is safe to assume that the US dollar will fall again. Accordingly, any equilibrium would be very short-lived.
A small-step incremental revaluation of the currency does not come without its own problems. But policy-makers must weigh the costs associated with the alternatives – namely, the impact of a swift and substantial revaluation of the renminbi that met the demands of US Congress and market speculators; say, a one-off 30–40% renminbi revaluation.
There are several problems with such a move. The first is job loss – the fundamental factor behind widespread domestic opposition to a large currency appreciation. In China there is a thing called domestic politics that involves a vast number of people, including 300 million underemployed rural labourers, who earn about $500 per year, and another 300 million immigrant workers, who earn about $1,000 per year. Such facts constrain policy-makers from making a move on the currency: the fact is they face even greater pressure to ease social disparities with more job opportunities.
But this is not the only problem. If a large appreciation were to solve the problem of China’s external imbalances once and for all, the Chinese authorities would have taken action. They would have then supplemented such a move with financial subsidies for those who would suffer the fallout.
Yet Chinese policy-makers are not yet certain that payments imbalances would be thus resolved. Jobs might be lost, but those lost jobs would not inevitably go to the US, but rather countries such as Vietnam or Bangladesh; the result might not reduce the US current account deficit. While such a move would be likely to placate US politicians in the short run, it wouldn’t necessarily satisfy them for long.
More importantly, the US dollar is falling fast and is likely to fall further given the current uncertainty in the financial markets. Seen in this light, it is fair for Chinese policy-makers to believe that even a 30% renminbi revaluation today might not prevent US Congress and market speculators demanding another hike again soon.
Even worse, between the large shocks (to the Chinese economy, Chinese SMEs and low-paid workers) caused by large revaluations, there would be greater speculation and greater capital movement – inward and outward – through various channels. China’s immature and fragile financial system would not be able to bear those risks.
So in the view of China’s policy-makers, the costs or risks associated with a swift one-off revaluation may be larger, and less predictable and manageable, than the costs associated with the current gradual approach – if their calculation extends beyond immediate consequences.
Self-interest
When it comes to its own interests, China must take a long-term perspective, not a short-term view. Today’s China is different from Japan of the 1980s, the oft-sought comparison. China is still a country with an income per capita of $2,000, and Japan was not a developing economy after World War II. While Japanese blue-collar workers earned a wage 80% that of their US counterparts in the 1980s, Chinese workers today earn 30 to 50 times less than their US counterparts earn.
China has far to go before it catches up. And during this long march, China will face much turbulence and risk – facts which could require exchange rate adjustments one way or another. From this point of view, it is wise for China to take small steps for now, to avoid overshooting or large swings. Capital controls are also necessary for a while to avoid overexposure to risks in highly volatile international financial markets.
This does not mean that China should ditch a market system or financial-market liberalization with a free-floating exchange rate regime in the long run. A developing country coming from a very low base needs different approaches to market-oriented transition, and hasty liberalization of a financial system and capital account in an underdeveloped domestic system (not only the financial but also all economic, legal and political components) could lead to a significant slowdown in both economic development and financial maturity – as shown by the Asia financial crisis of the late 1990s.
Compared with Indonesia and Thailand, China is an even more complex, low-level, developing economy with greater disparities and disorders. A gradual approach to currency revaluation may be more equilibrant in terms of long-term economic development.
The Chinese currency should be revalued as China’s productivity increases, and the country should improve its domestic economic structures so that the savings rate (currently 50% of GDP) can be scaled back, in order to moderate the current account surplus.
But remember that the exchange rate involves at least two currencies, not one. And the root of the problem might in fact lie on the other side of the equation. Finding out all causes of the problem doesn’t necessarily mean it can be fixed in short order, but at least it allows for a better understanding of the division of responsibility and the difficulties on both sides of the equation.
Excess global liquidity and the persistent decline of the dollar are just symptoms of a more profound cause of the ongoing global financial imbalances – the international monetary system itself, the so-called Bretton Woods II system, introduced in 1970 on the demise of the gold standard.
What has happened to international finance since then has yet to be fully understood. But what is clear is that we are still grappling with ways to shore up global governance to make globalization a more stable and just affair.
Fan Gang is professor of economics at Peking University and Chinese Academy of Social Sciences, and director of the National Economic Research Institute, China Reform Foundation