China is being pressured by the US government and others to appreciate its currency. Some even suggest that China has been “manipulating” its currency, a curious charge for a currency that effectively has been fixed at Rmb8.28 to the US dollar for over a decade.
Last July, China responded by altering its policies modestly, shifting as a reference point to a basket of currencies that included not only the US dollar but also the Japanese yen, the euro, and the Korean won, with less (unspecified) weight to be given to several other currencies as well. The People’s Bank of China (PBC) altered its dollar price to Rmb8.11, an appreciation of just over 2%, and allowed for greater intra-day movement in exchange rates.
Article IV of the International Monetary Fund’s charter, to which China has subscribed since 1980, says that each of
its members shall “avoid manipulating exchange rates ... to prevent effective balance of payments adjustment or to gain an unfair competitive advantage over other members”. This is where the term “manipulation” comes from. The same article says that each member shall “endeavour to direct its economic and financial policies toward the objective of fostering orderly economic growth with reasonable price stability, with due regard to its circumstances”, at which, by any standard, China has been spectacularly successful.
Has China violated its undertakings as a member of the IMF? Ultimately that is
a question for lawyers to decide, unless politicians become so impatient that they intervene first. What are the economic considerations?
Proponents of the “manipulation school” point to the dramatic increase in China’s foreign exchange reserves, a direct consequence of pegging the yuan to the dollar, from $166 billion at the end of 2000 to $711 billion at the end of June 2005. China’s current account surplus reached $69 billion during 2004, and its trade surplus has risen substantially in the first half of 2005. These facts, it is claimed, suggest that China’s currency is “undervalued”, and that an appreciation of the currency is called for. There is no doubt that if the PBC stopped its “intervention” (in effect, the PBC virtually makes the foreign exchange market for the yuan), it would under present institutional arrangements appreciate sharply in value.
It is suggested, furthermore, that appreciation of the yuan is in China’s interests, to help cool an unwanted investment boom, and is necessary to help eliminate disequilibrium in the world economy, epitomized by the huge US current account deficit of $660 billion in 2004.
Mistaken
These seem to be weighty arguments. I believe, however, that they are deeply misguided. They misunderstand the character of global imbalances today, and if seriously acted upon, they would jeopardize the most effective programme of economic growth and poverty reduction that the world has ever seen.
Take China’s perspective first. China indeed has had an investment boom that in late 2003 became worryingly strong to the Chinese authorities, and inflation began to increase. In their view, however, this was overwhelmingly a boom in construction, especially residential construction, and in the products used in construction – cement, steel, aluminium.
It should be said that China needs a lot of residential construction, as more people move into urban areas from the countryside, and as growing prosperity leads the Chinese to upgrade the size and the quality of their homes, and to permit young people to move out of their parents’ homes. But in 2003 the market became “frothy”, with signs of speculation in some cities.
The Chinese authorities moved cautiously to dampen the boom, relying on selective credit controls and taxes on real estate transactions, as well as on general tightening of fiscal policy and a relaxation of ceilings on interest rates. By mid-2005 these measures had begun to bite: inflation dropped from over 5% in mid-2004 to under 2%, and real estate prices began to fall in Shanghai, Guangzhou, and other major cities. A sharp currency appreciation could also have dampened the boom, but its impact would have fallen mainly on the industries engaged directly in international trade, not on the non-tradable construction industry.
Trade Surplus
China has run a trade surplus since 1990 (except for 1993), which reached a peak of $44 billion in 1998, generally declining thereafter until late 2004. It is true that China’s exports have grown exceptionally rapidly; but so have China’s imports. Some of these imports parallel directly the growth of exports, which are made up in significant measure of assembled components imported from elsewhere.
But China’s domestic absorption of imports has also grown rapidly. China is not systematically excluding foreign goods, and under the WTO accession agreements of 2000, China’s import barriers have declined substantially and are now among the lowest in the developing world. They are, however, still more restrictive than those in rich countries, and could be reduced further.
The increase in the trade balance in 2005 is due partly to the slowdown of the boom, partly to higher exports of clothing made possible by the long-planned expiration of export restrictions under the Multifibre Agreement at the beginning of 2005.
The larger current account surplus in the last several years includes substantial “remittances” from Chinese abroad, really a return of capital that was exported during the past two decades, drawn in part no doubt by the real estate boom in China, but in part perhaps also by hope of gain on a revaluation of the yuan.
Outstanding achievement
China has experienced robust growth in recent years, has maintained reasonable price stability, and has moved hundreds of millions of people out of poverty, both on the Chinese definition and on international definitions. It is a story of extraordinary continuing economic success – 70% of the labour force was in agriculture 20 years ago, now below half. China’s success has also benefitted its customers and its suppliers around the world. It should not be placed in jeopardy, as a substantial appreciation of the currency might do.
The other putative reason for revaluation of the yuan is that it would contribute to reduction of global imbalances, especially the large US current account deficit. That is too complex a topic to be analysed satisfactorily in the space remaining. Suffice it to say that even if China’s current account surplus, $68.7 billion in 2004, had been eliminated entirely, and that if all this elimination implausibly accrued to the United States, it would have reduced the US deficit by barely more than 10%. Few countries are likely to follow a Chinese lead in a major revaluation, contrary to the hopes of some of the manipulation school; most would welcome the gain to their own competitiveness.
The large US deficit has its origin in factors other than the peg of the yuan to the dollar. There are few promising investment opportunities in ageing Europe and Japan, yet savings remain high there. Investment opportunities exist in many emerging markets, but the financial crises of the past decade, combined with more recent confiscatory actions in Argentina and Russia, counsel caution in investing in those countries.
The United States is a large, robust economy with an excellent financial market and secure property rights. It is not surprising that savers around the world choose to invest in the US economy, and in US securities.
During 2004, almost $1.4 trillion in private foreign capital entered the United States, nearly twice the current account deficit. Indeed, if China did not maintain strict controls on capital outflows, many Chinese, with their high savings rate, might also invest in the US economy – perhaps even enough to outweigh China’s current account surplus.
This strong possibility is enough to raise serious questions about the claim that the yuan is “undervalued”. China is well advised not to eliminate capital controls quickly, given the fragility of its domestic financial structure, but it could and should do so gradually, anticipating a fully convertible yuan sometime in the coming decade.
Richard Cooper is Maurits C Boas Professor of International Economics at Harvard University