Since China revalued its currency and abandoned the yuan peg-to-the dollar policy in July 2005, the yuan has increased by 9.4 percent against the dollar (as of the end of July 2007). How far should this process go? Is the further revaluation of the yuan beneficial to China, the U.S. and the world?
The Myth of Undervaluation
The U.S. Senate just passed two bills aimed at pressing China to revalue its currency. The Finance Committee bill included levying penalizing duties on imports from currency "fundamentally misaligned countries." The Banking Committee bill instructs the administration to determine "currency manipulation without regard to a country's intent." Both protectionist legislations were based on an assertion that the Chinese currency is undervalued by as much as 40 percent, which has caused huge U.S. trade deficits and massive unemployment in the manufacturing sector.
The allegation, however, that the yuan is undervalued by 40 percent is arbitrary and totally ungrounded. To be sure, in tandem with high export growth and current account surplus, there is a general perception that the Chinese currency is grossly undervalued. But determining the extent of the renminbi's undervaluation is not an easy matter. If one looks at the yuan on a trade-weighted basis, or relative to the dollar with adjustments for productivity, the yuan is evidently undervalued.
But in globalization days, investment flows have grown in an electronic age, with daily transactions worth billions and even trillions of dollars. Trade flows constitute only a tiny fraction of the foreign exchange transactions. This greatly complicates the determination of the value of a currency. It would be highly misleading to judge a currency's value only, or mainly, on the purchasing-power-parity (PPP) basis, which is supposed to equalize the price of a basket of goods in any two countries. But one should know that price depends heavily on local inputs such as wages and rent, which are not easily arbitraged across borders and tend to be much lower in China and other developing countries. So, the PPP is comparable only between countries at a similar stage of development. For this reason, China's huge trade surplus does not necessarily mean that its currency is undervalued. Moreover, it is especially difficult to determine whether a currency is undervalued or overvalued in a nonmarket economy like China. The capital account is under strict control in China now, and a real foreign exchange market is yet to be established. The yuan's exchange rate cannot be regarded as the market equilibrium rate, nor can it serve as a true mirror of the country's real supply and demand for foreign exchange. Once the Chinese capital market is liberalized and the yuan becomes convertible, with enormous and relatively liquid balances in the Chinese banking system, free capital outflow would carry with it a severe danger of currency crisis if demand for U.S. dollars exceeds demand for the yuan. Then the renminbi actually would be overvalued rather than undervalued.
Reliable Chinese sources estimate, based on economic fundamentals and excluding short-term bubble factors, that the yuan might be undervalued by 6.5 to 10 percent. The main impetus for the equilibrium exchange rate's upward trend was technological progress induced by structural reform and foreign investment. As mentioned above, the yuan has already appreciated by 9.4 percent since 2005; there is no need for further revaluation in the near future.
Does China Need Exchange Rate Flexibility?
U.S. policy makers also emphasize China's need for exchange rate flexibility. Treasury Secretary Henry Paulson and other administration officials keep pressing China to increase the flexibility of the exchange rate and to transition to a market-determined exchange rate. In fact, this strategy sounds like pressure for revaluation. International experience shows that with a weak financial and banking system, it would be disastrous for a country to adopt a floating and flexible exchange rate policy. The yuan's rate cannot be market-driven simply because there is no foreign exchange market in the real sense. The nominal foreign exchange market in Shanghai actually is a "swap" market. There are no dealers or market makers, who might enhance liquidity and form the real market prices. In the absence of futures and options markets, state-run and private companies have limited ways to avoid foreign exchange risks. China, like many developing countries, has to use government intervention in currency markets to keep its exchange rate stability, and, by using capital controls, to restrict speculative investment activity. Only when its capital controls are relaxed, will exchange rate flexibility be necessary to encourage orderly investment flows.
As a result of intervention and capital control, China has a stable exchange rate that is a high policy priority, because the country still has hundreds of millions of people who eke out a marginal living and cannot afford the volatility of free capital flows and unstable exchange rate movements.
U.S. officials and economists admit that even if China revalued its currency by 20 to 40 percent, the U.S. trade deficit might not shrink, since consumer goods exported from China to the U.S. would probably be replaced by other low-cost producers in Asia or Latin America, not by U.S. producers. U.S. consumers would face higher prices. Meanwhile, China's growth could slow considerably, with global repercussions.
It seems that before hectoring China to lift its capital control and adopt a flexible, free-floated exchange rate, it is better for the U.S. and other developed countries to help China fix its state-owned enterprises, especially the banking sector, marketize the interest rate mechanism, clarify the property rights, establish a real foreign exchange market, and create a true market economy.
Real Exchange Rate Matters
One of the solutions to the U.S.-China dispute on trade and currency might be appreciation of the Chinese real exchange rate instead of increasing the nominal exchange rate. In order to stimulate domestic consumption, reduce trade surplus with foreign countries, and relieve pressure for yuan's nominal exchange rate appreciation, Chinese authorities could consider the following measures:
(1) Significantly increasing labor costs: raising salaries and wages of workers and farmers working in urban areas; boosting relative price levels of land, rents, resources, and all consumer goods; thus promoting appreciation of the real exchange rate, increasing the cost of exports and reducing the trade surplus. By raising the wage/price level, China would not only reach external equilibrium, but also greatly stimulate domestic demand.
(2) Eliminating export tax rebates, to discourage exports. (Effective July 1, 2007, the authorities already abandoned tax rebates for some export products and lowered the rebate rate for other products.) All remaining rebates should be abolished as soon as possible.
(3) Levying environmental taxes, especially for those foreign export-oriented enterprises, thus increasing the cost of exports.
(4) Gradually revoking preferential treatment for foreign enterprises, in order to discourage capital inflows and reduce foreign exchange reserves. In the future, such preferences should be stipulated by the central government, not by local authorities.
Incremental appreciation of the nominal exchange rate, as the government is doing now, would harm the Chinese economy. Given the unprecedented amount of "hot" money flowing into China in anticipation of the yuan's appreciation, the creeping revaluation of the yuan would only benefit these currency speculators, and damage Chinese export enterprises, employment and consumers.
China's trade surplus is not accumulated by an undervalued yuan's exchange rate. Rather, it basically stems from an almost unlimited supply of low-cost surplus labor, an improvement of labor quality, a higher productivity and technological progress, and a drop of transaction costs due to structural reforms. Therefore, it is unwise to press China to revalue its currency for the purpose of reducing the U.S. trade deficits.
The U.S. political pressure in regard to revaluation has attracted speculative capital inflows into China, causing a massive buildup of foreign exchange reserves. This behavior, in turn, has led to internal and external imbalances in China, neutralized China's effort in experimenting with greater flexibility in its exchange rate regime.
The U.S. and China could make joint efforts to increase China's real exchange rate, reform China's financial and banking system, and create a real exchange rate market before the currency becomes market-driven.