China and Currency Valuation

by Daniel J. Ikenson

Will the Treasury Department's semi-annual report on foreign-exchange-rate practices, due to be released in April, label China a "currency manipulator," as is being increasingly speculated? If so, that conclusion would spark bilateral negotiations on an "expedited basis" and open the door to "remedial" legislation to compel China to revalue its currency.

For Congress and President Obama, the issue is not the undervalued renminbi per se, but the large bilateral trade deficit with China. To them, currency revaluation is a proxy for reducing the trade deficit to zero — or better yet, turning it into a surplus. But trying to legislate trade balance is a fool's errand.

Daniel J. Ikenson is associate director of the Cato Institute's Center for Trade Policy Studies.

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Many economists, citing China's approximately $2.4 trillion of accumulated foreign reserves, believe that the renminbi ("the people's currency," denominated as the yuan) is in fact undervalued. They disagree about the magnitude of the undervaluation, and there is a good reason for that. Nobody can know the true value of any currency unless that currency floats freely and there are no restrictions on capital flows. Unless China permits those things to happen, economists can only continue to produce their widely varying estimates of the renminbi's undervaluation.

It's true that no matter what China does about its currency, many in Washington will argue that the renminbi is undervalued as long as U.S. imports from China exceed U.S. exports to China. But will renminbi appreciation have the intended effect of reducing the bilateral trade deficit? The empirical evidence says it won't.

Between July 2005 and July 2008, the renminbi appreciated by 21 percent against the dollar. The bilateral trade deficit increased from $202 billion in 2005 to $268 billion in 2008. U.S. exports to China did increase, as expected — and by a healthy $28.4 billion, or 69.3 percent. But the proportion of that increase ascribable to renminbi appreciation is very much debatable.

U.S. exports to China were already on an upward trajectory. They had increased by $19.1 billion during the previous three-year period, when the yuan was pegged at 8.28 per dollar. The increase in the latter period could be attributable to natural sales growth from the market penetration and cultivation that were already evident. Furthermore, in 2007 and 2008, when renminbi appreciation was strongest (at 4.7 percent and 9.5 percent, respectively), the annual increases in U.S. exports to China were progressively smaller.

On the import side, the evidence is not compelling that an appreciating renminbi deters U.S. consumption of Chinese goods. As the renminbi was growing stronger between 2005 and 2008, U.S. imports from China increased by $94.3 billion, or 38.7 percent. Not only did Americans demonstrate strong price inelasticity, but they actually increased their purchases of Chinese imports, in seeming defiance of the law of demand.

One reason for continued U.S. consumption of Chinese goods despite the relative price increase may be that there is a shortage of substitutes for Chinese-made goods in the U.S. market. In some cases, there are no domestically produced alternatives at all. Accordingly, U.S. consumers were faced with the choice of purchasing higher-priced items from China or forgoing consumption of an item altogether.

It is doubtful that members of Congress who support action to compel Chinese currency appreciation would proudly announce to their constituents that they intentionally reduced American real incomes. But that is the effect of relative dollar depreciation.

Something else is evident from the period 2005–2008. The fact that a 21 percent increase in the value of the renminbi was met with a 38.7 percent increase in the value of Chinese exports means that the quantity of Chinese goods demanded by Americans after the revaluation increased by 14.6 percent. The law of demand simply cannot be defied in the way those figures suggest. It is clear that what happened is that Chinese exporters lowered their prices in yuan so as to keep steady or reduce the prices paid by U.S. customers after the currency conversion. That was a rational move, enabled by the fact that renminbi appreciation would have reduced the cost of production for Chinese exporters — particularly those who rely on imported raw materials and components.

According to a growing body of research, somewhere between one-third and one-half of the value of U.S. imports from China is actually Chinese value-added. The other half to two-thirds reflects costs of material, labor, and overhead from other countries. A stronger renminbi makes imported inputs cheaper for Chinese producers, who can then reduce their prices for export. This mitigates the effect of currency realignment desired by American politicians, which is to reduce American imports from China.

The world would be better off if the value of China's currency were truly market-determined, allowing better resource allocation. But compelling China to revalue under threat of sanction is unlikely to produce the desired results and quite likely to spark costly reprisals — and leave a lot of people worse off.