SPEAKING
FREELY Yes, Virginia, it's the
yuan By Peter Morici
Speaking Freely is an Asia Times
Online feature that allows writers to have their
say. Please click hereif you are interested in
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COLLEGE PARK,
Maryland - Of late, it has become conventional
wisdom that the focus of various US politicians on
the yuan-dollar exchange rate is misplaced.
Those who hold this view, including the
Chinese government and many commentators both in
Asia and in the West, have argued that the US is
faced with underlying structural problems that the
yuan-dollar rate has little to do with. They
further contend that the China-US wage
differential, a major cause of the United States'
trade deficits with China, is currently so large
that revaluation of
any
conceivable magnitude would do little to address
it.
But what about the counter-argument?
Are there any good reasons to believe that
revaluation would help to alleviate
structural problems, not only in the US but in
China as well? Actually, there are.
The
background: China's economic boom Since the
late 1970s, economic reforms in China have
propelled modernization and growth. Town and
village enterprises, private entrepreneurs and
foreign multinationals have played key roles in
establishing markets and bringing advanced
technology to a formerly state-planned economy.
Though diminished in relative importance,
large state-owned enterprises still significantly
drive growth in major industries such as
automobiles and steel, but have also profited from
joint ventures with Western companies.
As
in most developing countries, national and
provincial governments have sought to guide
development through a variety of industrial
policies. These include trade barriers, tax
preferences, access to credit, and limits on
equity participation and performance requirements
for foreign investors. The last reserve
significant segments of the industries for
domestic enterprises and require foreign investors
to bring to China technology and know-how that
will instigate progress beyond their own
enterprises.
Given the rapid growth in
Chinese productivity and large inflows of foreign
investment, the yuan would be expected to
appreciate in value over time. However, Chinese
economic policymakers see the exchange rate for
their currency as a critical development tool.
Like other governments in Asia, Chinese monetary
authorities have intervened in foreign-exchange
markets, consistently trading yuan for dollars and
other reserve currencies to maintain a steady
value for their currency. In turn, many of these
currencies are converted into
foreign-currency-denominated interest-bearing
assets, such as US Treasury securities, which help
finance the US federal budget deficit.
China's currency policy In 1995,
the Chinese government pegged the yuan at 8.28 per
US dollar. Last July, it adjusted that value to
8.11 and announced that the yuan would be aligned
to a basket of currencies; however the yuan still
tracks the dollar quite closely, with little
day-to-day variation, and by the end of April was
trading at about 8.02 per dollar.
In 2005,
Chinese monetary authorities purchased $206
billion in foreign currency (mostly US dollars)
and securities, or about 9% of Chinese gross
domestic product (GDP) and 27% of its exports.
These purchases result in an off-budget subsidy
for exports and on products made in China
competing with imports. By boosting exports and
limiting imports, these purchases distort
investment decisions in China and the United
States, and contribute importantly to the large US
trade deficit.
Consequences for the US
economy US trade deficits are caused by
many factors. The federal government budget
deficit, which was $318 billion in 2005, and low
US private savings play a role. But neither is
enough to account for the trade deficit, which hit
$805 billion last year. Foreign government
purchases of US securities are significant, and
how these work into the process is important.
With imports exceeding exports, either
private foreign investors provide Americans with
enough foreign currency, through loans and asset
purchases, to finance the difference, or the
supply of dollars will exceed the demand on
foreign-exchange markets and the value of the
dollar will fall. This would make imports more
expensive in the United States, and US exports
less expensive abroad. Since prices affect what
people buy, the US trade deficit and other
countries' trade surpluses should shrink.
Instead, foreign central banks have been
stepping in, purchasing dollars with their
currencies, and truncating this process. China is
by far the biggest player.
Private capital
flows are much more erratic than trade flows,
which generally trend upward over time. Central
banks have been adjusting their purchases of
dollars to accommodate fluctuations in private
foreign investment into the United States. For
example, their purchases of US dollars were $279
billion, $395 billion and $221 billion in 2003,
2004 and 2005, and quarterly data exhibit even
wider proportional swings.
Central banks
convert the dollars they purchase into US
securities, which in turn drives down US interest
rates. This is one reason US long-term rates have
remained low even as the Federal Reserve has
raised the overnight bank borrowing rate, and US
housing prices have risen so much. The resulting
increase in wealth on the balance sheets of
ordinary US consumers causes them to spend more
and not save very much from their wages and
ordinary sources of income.
Without
central-bank intervention in foreign-exchange
markets, Americans would export more, import less,
and save a lot more. Also, US investment would not
be skewed so much toward housing and be more
directed toward expanding export and
import-competing industries.
Larger trade
deficits with China and other Asian economies have
shifted US employment from export and
import-competing industries toward activities that
do not compete in trade. Export and
import-competing industries create about 50% more
value added per employee than non-trade-competing
industries. Hence larger trade deficits reduce GDP
- to the tune of $250 billion to $300 billion in
2005, by my estimate. Conversely, reducing the
trade deficit would increase US incomes and tax
receipts, though not by enough to eliminate the
federal budget deficit.
To get rid of the
trade deficit altogether, the US government would
have to learn to live within its means and
Americans would have to save more. But if the
dollar were permitted to fall against the yuan and
other currencies, adjustments in asset markets and
higher US incomes would increase tax revenue and
create more domestic savings. These would make
working down the trade and budget deficits more
manageable.
Consequences for China's
economy Currency intervention has important
consequences for the Chinese economy too. For one
thing, it shifts investment into export and
import-competing industries, and encourages
population movements toward and necessitates
infrastructure investment in the cities that
support these industries.
To some extent,
these investments are accomplished at the expense
of needed projects in the interior and rural
areas. Without currency-market intervention, China
would not grow more slowly so much as it would
grow differently. The benefits of modernization
would be more evenly spread throughout the
country, and the large disparities in wealth
created by the export boom would be lessened.
As important, the yuan printed by China's
monetary authorities to purchase dollars on
foreign-exchange markets create considerable
liquidity and inflationary pressures in China when
these return to the country as payment for
imports. To mitigate these pressures, China's
monetary authorities must persuade domestic
investors to purchase yuan-denominated government
bonds - a process called sterilization - and
evidence is growing that the Chinese government is
reaching the limit of its ability to sell these
bonds. If China keeps printing yuan to help
Americans pay for more and more imports, it will
face unwanted domestic liquidity and inflation.
China's trading partners - in Europe, as
well as the United States - are growing restive
with the undervaluation of the yuan. Down the
road, China's currency policy, and those of other
countries intervening in foreign-exchange markets,
has the potential to cause the United States and
Europe to close their markets. Ultimately, this
could derail the global trading system, and the
viability of the World Trade Organization could be
threatened.
Revaluing the
yuan By some estimates, the yuan is as much
as 30-40% undervalued. But revaluing abruptly by
this entire amount would threaten the viability of
many Chinese state-owned enterprises, disrupt
Chinese labor markets, and significantly stress
the balance sheets of Chinese banks.
But
this is not necessarily an argument for inaction,
because adjustments of these kinds will only be
larger if the yuan is revalued two, three or five
years from now. In the meantime, Chinese monetary
authorities would have to purchase ever-larger
amounts of dollars and face increasing domestic
inflationary pressures as they encounter the
limits of sterilization.
Further, China
risks the United States and other Western trading
partners closing their markets or imposing other
measures to stem their escalating trade
imbalances. Revaluing the yuan in steps would
permit China to thread a delicate policy course
that avoids both the hazards of abrupt revaluation
and the perils posed by stubborn procrastination.
The US is dependent on Chinese and other
foreign-government purchases of Treasury
securities to finance its federal budget deficit.
Absent this intervention, the exchange rate for
the dollar and the US trade deficit would be
lower, and GDP and tax revenue would be higher,
but the additional taxes would not reduce the
federal deficit by enough to replace these foreign
purchases of Treasury securities.
To close
the federal financing gap, the Federal Reserve
could purchase additional Treasury securities to
maintain interest rates. It routinely purchases
Treasuries to expand and regulate the money
supply. Instead of the Chinese and other foreign
monetary authorities purchasing Treasury
securities, the Federal Reserve would make those
purchases.
However, were exchange rates
adjusted too quickly and foreign government
purchases of Treasury securities terminated too
abruptly, these Fed purchases would be too large.
The US money supply would expand too quickly, and
inflationary pressures in the US would result.
Again, these problems could be avoided if exchange
rates were adjusted in an orderly and predictable
fashion.
A reasonable middle course might
be for China to revalue the yuan immediately, by
10%, and then permit the targeted rate for the
currency to rise 1% a month thereafter. This would
gradually reduce Chinese currency-market
intervention until it was no longer needed. At
that point, likely after about three years, the
yuan could be left to float without government
interference.
Peter Morici is a
professor at the University of Maryland's Robert H
Smith School of Business, former chief economist
at the US International Trade Commission, and a
commentator on economic and political issues.
(Copyright 2006 Peter Morici. Used with
permission.)
Speaking Freely is an
Asia Times Online feature that allows writers to
have their say. Please click hereif you are interested in
contributing.
