The story of China’s economic growth is well known and documented over the years. Following substantial renminbi (RMB) devaluation in 1994 and the subsequent opening of the economy to FDI, along with a number of incentives offered by the Chinese government, multinational companies started to relocate production to China. The Chinese export machine went into overdrive after World Trade Organization accession in 2001. Total Chinese exports in 2000 were $249.5 billion, but by 2008 (before the world consumption slowed down due to the global financial crisis) they climbed to $1.430 trillion. China’s current account surplus in 2001 was a mere $17 billion. By the end of 2008, it was approaching $400 billion. As exports expanded, the authorities in Beijing consistently bought dollars to avoid appreciation of their currency. According to some estimates the Chinese authorities buy about $1 billion daily in the exchange markets to keep their currency from rising and thus to maintain an artificially strong competitive advantage.
In a standard macroeconomic model, exchange rate intervention should lead to monetary expansion, which in turn drives up domestic prices, nullifying the real effect of intervention. China’s financial system, however, is owned and managed by the government. Capital controls are in place for most non-FDI capital flows. Sterilization and bank lending policies are governed by decree, so that the government can force banks to buy trillions of low-yielding RMB sterilization bonds or alter their reserve ratios. Deposit and lending rates are also set by the government. This has allowed China to intervene in the foreign exchange market while retaining total control over domestic monetary aggregates.
Although this policy has worked well for both China and the United States (export growth for China and cheep imports and public debt financing for the United States), the unintended consequence of sustained currency intervention was a vast accumulation of dollar-denominated securities in the reserves of the People’s Bank of China and the State Agency for Foreign Exchange (SAFE). At 2000 China had currency reserves of $165 billion, slightly above 10 per cent of GDP. By the end of 2009 currency reserves had reached $2.4 trillion, equivalent to more than 50 per cent of China’s annual GDP.
In the depressed conditions caused by the financial crisis, China’s dollar peg poses two main threats. First, it limits U.S. recovery by overvaluing the dollar in key Asian markets and therefore artificially raising the price of U.S. exports. (In theory, to be sure, the United States could deflate its currency to regain competitiveness against Asian currencies, but deflation is out of the question for such a highly leveraged economy.) Second, with inflows of hot money straining the system of sterilization to breaking point, the RMB-dollar peg is now contributing to a dangerous overheating of China’s economy; appreciation of the currency would complement the recent increases in bank reserve requirements, helping to cool down the rampant over-investment in manufacturing capacity and urban real estate.
Therefore, the U.S. needs deflation of its currency, but the world economy also needs rebalancing. Many U.S. experts believe that the RMB is 25% to 40% undervalued, and members of the U.S. Congress have demanded action from the U.S. administration. According to experts, elimination of the Chinese misalignment would create as many as half a million U.S. jobs, mainly in manufacturing, over the next couple of years, at zero cost on the U.S. budget. However, Tim Geithner, the US treasury secretary, has resisted direct confrontation with China over the RMB value. Like his predecessors, he worries that overt pressure would erode co-operation on other issues such as nuclear proliferation by Iran and North Korea.
During the past 10 years alone, the Chinese currency which stood steady at 8.27 RMB per dollar at the beginning of the decade, appreciated to 6.83 RMB (17.41%) during the period of July 2005 to July 2008, where it stood steady for a couple of years, before appreciating again during the past seven months. Since June 2010, the RMB has appreciated only 3% (from 6.83 to 6.63 RMB). If past behavior is an indication of future course of action, a 25% appreciation of the RMB will take at least over 5 years, and it will only happen at a pace comfortable for the Chinese government.
Rather, experts have suggested that only a tariff on all Chinese imports will have a definite impact on the global trade imbalance. A 25 to 40% tariff on imports from China will have the same effect like a 25 to 40% devaluation of the RMB. Such a tariff will definitely slow down Chinese exports to the U.S., but it could also generate some much needed domestic consumption in China. More consumption by Chinese and other South-East Asian citizens is the only equitable solution to the global trade imbalance. Of course, such a unilateral action by the US will live the EU, and other world markets exposed to Chinese exports. This is why the U.S. needs to mobilize a multilateral coalition to press China to let its currency rise by the needed amount.
Experts recommend that negotiations similar to those of the Plaza Agreement of 1985 should be launched immediately to coordinate a substantial (40 to 50 percent) revaluation of a number of managed Asian currencies versus the dollar and the euro over the next two to three years. This would also have to entail an agreement to halt strategic currency management activities. This is because many other Asian currencies are undervalued due to their peg to the RMB, including Hong Kong, Taiwan, Singapore and Malaysia. Labeling all these countries as currency manipulators and demanding appropriate adjustment by all of them might be more appropriate then just singling out China. Doing it through the G-20, would add further legitimacy to such a bold and decisive course of action.
Of course, as long as the U.S. is not willing to act boldly in cooperation with the EU and other emerging economies, the Chinese will continue to incrementally ‘manage’ their currency, thus perpetuating the global trade imbalance.
Now, if you don’t believe me, just watch this ‘expert’ explanation offered by bears. It’s very good… and very funny! Enjoy…
The Bears Talk China\’s Manipulated Currency
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