China Bashing Over Yuan Needs a Long Rest: Ronald I. McKinnon
Commentary by Ronald I. McKinnon
July 6 (Bloomberg) -- I’ll say it at the outset: Focusing on the yuan-dollar rate is a serious distraction, and it’s time for the U.S. to back off from bashing China over problems that are born mostly at home.
Let’s start with the source of all the misdirected attention. On June 20, the People’s Bank of China bowed to American pressure and said it was abandoning the peg of 6.83 yuan to the dollar. Now the bank will vary the exchange rate at the beginning of each trading day, as well as widening the range of variation to plus or minus 0.5 percent.
But the PBC is concerned about re-introducing the one-way bet that prevailed between July 2005 and July 2008: that the currency steadily rises as it did at about a 6 percent annual rate. This led to massive inflows of hot money that threatened a loss of monetary control while impeding the forward market in foreign exchange.
China’s central bank is again in a difficult situation. The U.S. Congress, led by New York Senator Charles Schumer, again is threatening to impose punitive tariffs on imports from China unless the yuan appreciates. Thus China’s ritualistic de-pegging exercise to defuse American pressure.
Yet any gradual appreciation, or even the threat of it, will restart the hot-money inflows. Moreover, any sharp appreciation won’t defuse the situation because it will be unlikely to reduce China’s trade surplus, mainly the result of that country’s high savings rate.
False Belief
Unfortunately, what lies behind this unnecessary political crisis is a widely held but false economic belief: the idea that the exchange rate can be used to control any country’s trade balance, which is the difference between its saving and investment rate. Instead, the problem is a saving deficiency in the U.S. -- with very large fiscal deficits and low personal saving -- coupled with surplus saving in China.
To correct the trade imbalance between the two countries, these fundamentals must be jointly altered by changes in public policies.
Nobody disputes that almost three decades of U.S. trade and net saving deficits have made the global system of finance and trade more unstable. Dollar debts outstanding have become huge, and threaten America’s own financial future.
Because the U.S.’s main creditors in Asia -- Japan in the 1980s and 1990s, China since 2000 -- rely heavily on exports, the transfer of their surplus savings to the U.S. entails that they run large trade surpluses in manufactured goods.
The result has been that U.S. trade deficits have worsened the decline in the American manufacturing sector.
Industrial Decline
One unfortunate consequence of this industrial decline has been an outbreak of protectionism in the U.S., which is exacerbated by the conviction that foreigners have somehow been cheating with their exchange rate.
However, the prevailing idea that a country’s exchange rate could, and indeed should, be used to bring its external trade into better balance is often wrong.
This conventional wisdom is based on faulty economic theorizing. It need not apply in a globalized financial system where capital flows freely.
There are several forces at play tied to a simple economic formula with exports and imports on one side and saving and investment on the other.
Most economists and commentators focus on exports and imports. Looking at this alone suggests that a depreciation of the home currency will make its exports cheaper in world markets and make the home country’s imports more expensive, leading to an improved trade balance.
Whole Picture
But that’s not the whole picture. For the trade balance to improve with currency depreciation, overall domestic expenditures must fall relative to aggregate output. This is the same as saying that domestic saving must rise relative to domestic investment. Looked at this way, one can’t presume that U.S. net saving will rise when the dollar is devalued.
Indeed, the presumption may go the other way when domestic investment (fueled in part by multinational firms) is sensitive to the exchange rate.
Suppose the yuan were to appreciate a lot against the dollar. Potential investors -- either foreign or domestic -- would now see China to be a more expensive place in which to invest and the U.S. less expensive. This might set off a minor investment boom in the U.S., where investment expenditures rise from a relatively small base, and a major slump in China’s huge investment sector, which now is about 45 percent of the country’s annual output. Overall, investment-led expenditures in China would fall, the economy would contract, and Chinese imports might fall.
Japan Lesson
So why wouldn’t the trade imbalance between China and the U.S. be reduced? Let’s look to Japan to see what happened when it allowed its currency to appreciate in the 1980s into the mid- 1990s, when the yen went ever-higher.
Japan became a higher-cost place in which to invest, so that large Japanese firms decamped to invest in lower cost Asian countries and in the U.S. Yet, even though yen appreciation slowed Japan’s export growth, because its economy slowed and imports declined, the trade surplus with the U.S. still increased.
No wonder China is reluctant to appreciate. Like Japan, its trade and saving surplus would likely not diminish because domestic saving is relatively insensitive to the exchange rate.
Critics in the U.S. and Europe might well come back and say “you just didn’t appreciate enough.” But continual yuan appreciation is an invitation to further hot money inflows. The People’s Bank of China would be, as it has been, forced to intervene to buy dollars on a grand scale to prevent an indefinite upward spiral in the yuan.
So we need a permanent moratorium on bashing China to appreciate its exchange rate, allowing China’s central bank to stop its obscure fiddling with the yuan-dollar rate. The U.S. should work toward a credible program for closing its enormous fiscal deficits and encouraging personal saving, while China works on reducing incentives for corporate over-saving by allowing a freer labor market and more rapid wage growth. But these are stories for another time.
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