Yuan Step at a Time

Bringing my export revenues to the foreign exchange kitty

China’s 12-month trade surplus rose in May to $118 billion, while its current account for 2005 bulged with $161 billion in the kitty. And, to complete the eye-popping figures, its foreign reserves hit a whopping $875 billion in March this year.

Across the Pacific, the US’s trade deficit for the 12 months to April was $815 billion, while its current account ended last year $805 billion in the red. Small wonder that many US congressmen are baying against what they perceive as China’s “unfair practices”. By keeping its currency grossly undervalued, they argue, China’s exports are artificially cheap, thus lending it an uncompetitive advantage. The 2.1% revaluation of July last year is not enough, they say, insisting the yuan should be revalued further.

But would that solve the US’s current account problems and reduce China’s trade surplus and its insatiable appetite for foreign reserves? Not so quick, warn CESifo fellows Ronald McKinnon, of Stanford University, and Gunther Schnabl, of Leipzig University, in their latest CESifo Working Paper. An appreciation of the Chinese currency would not necessarily reduce its trade surplus, they say, but could cause serious deflation in China. It should better be left untouched.

To explain why, they first cast a glance back to Japan’s unsuccessful appreciation of the yen and compare it to a putative international adjustment between China and the United States from both an asset-market and a labour-market perspective. The current US-Chinese trade frictions are reminiscent of the US-Japan frictions from the 1970s to 1995. Back then, the seemingly relentless penetration of Japanese manufactured goods into the American market gave rise to repeated fits of Japan bashing among US politicians and media.

This bashing prompted Japan to apply some appeasing measures, such as “voluntary” restrictions in exports to the US and a gradual appreciation of the yen, which rose from 360 to the dollar in August 1971 to a peak of 80 in April 1995. By then, the slump in the Japanese economy was all too evident, enough to worry even the US. Japan bashing all but ceased there.

But it has now been replaced by China bashing. After Japan’s disastrous rise of the yen, it pays to cast a closer look, when analysing the choice of an exchange rate regime in a economic catch-up process, at the response of interest rates in asset markets, and to consider wage adjustment in labour markets, should such an appreciation be pushed through.

The thorough analysis performed by the authors covers a lot of territory, starting with Japan’s era of high economic growth in the 1950s and 1960s. At that time, Japan's current account was nearly balanced and its foreign reserves surprisingly low, while the US was fiscally well behaved and ran moderate current account surpluses. Under President Ronald Reagan, however, this good behaviour changed. In Japan, meanwhile, looser exchange controls and a more developed capital market led to its posting large current account surpluses that became chronic, matching corresponding US current account deficits.

But unlike Japan in its economic catch-up period, China—which is still fully immersed in its own catch-up sprint, with very rapid economic growth, capital controls, underdeveloped domestic financial markets, and low per capita income—has already become a major international creditor. The authors’ analysis shows that for countries in the economic catch-up process with underdeveloped capital markets foreign exchange constitutes a much larger problem that for the highly developed United States or euro area. Both underdeveloped capital markets and a sustained real appreciation pressure resulting from relative productivity gains can lead to micro and macroeconomic instability as the exchange rate fluctuates.

A fixed exchange rate against the dollar, they show, ensures asset market equilibrium between the creditor country China and debtor country United States. By credibly fixing the exchange rate, deflationary pressure and the fall into a so-called zero-interest liquidity trap is circumvented. In labour markets, in turn, uncertainty is reduced under fixed exchange rates because trade unions and enterprises can more easily keep wage settlements in line with productivity growth. Under this light, China would do well to keep its exchange rate tightly pegged to the dollar as long as its economic catch-up process continues and its capital markets remain underdeveloped.

Given time, the current imbalances will diminish, and the China-bashing it prompts will subside. Until another fast-rising economic power (India, perhaps?) takes up that role.

Ronald McKinnon and Gunther Schnabel: China’s Exchange Rate and International Adjustment in Wages, Prices, and Interest Rates: Japan Déjà Vu?, CESifo Working Paper No.1720

• Other CESifo Working Papers dealing with China
• Other CESifo Working Papers dealing with currency matters
• Other CESifo Working Papers by Ronald I. McKinnon
• Other CESifo Working Papers by Gunther Schnabl
• CESifo Working Papers published in the past three months