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China's Currency Impact

Yuan revaluation is at the heart of US manufacturing concerns.

TW Special Report

T he implications of increased economic relations between the United States and China have been the topic of debate for some time - particularly as China acceded to the World Trade Organization (WTO). Often, the discussion devolves into a trade theory argument. In a search for clarity, following are direct excerpts from The US-China Economic and Security Review Commission's Report to Congress, published in June 2004. The 290-page report details growing concerns reached through a broad and bipartisan consensus.

The report summary states: "Based on our analyses to date, as documented in detail in our Report, the Commission believes that a number of the current trends in US-China relations have negative implications for our long-term economic and national security interests, and therefore that US policies in these areas are in need of urgent attention and course corrections."



The overvaluation of the dollar against the world's currencies has been a major contributing factor in the worsening of the US trade deficit over the last several years. Of particular concern is the undervaluation of the yuan [currency of China] against the dollar. China pegs its currency to the dollar, and the yuan has traded at 8.28 per dollar since 1998.

During this period, China has experienced massive export sector productivity growth driven by FDI [Foreign Direct Investment]. This situation has enormously strengthened China's competitive advantage, rendering the yuan undervalued. In a free market, China's productivity growth, trade surplus and inflows of FDI would have caused significant exchange rate appreciation. However, China systematically intervenes in the currency market to prevent this from happening, thereby maintaining an important competitive advantage for Chinese exports.

Impact Of China's
Exchange Rate Policies On US Trade

International trade is dominated by manufacturing trade, and overvaluation of the dollar has significantly reduced the international competitiveness of US manufacturing industry. This lack of competitiveness is reflected in the growing US trade deficit, which has negatively impacted manufacturing output and employment. The negative effects of the overvalued dollar on manufacturing operate through several channels.First, overvaluation makes exports relatively more expensive, reducing foreign country demand for US manufactured goods.

Second, overvaluation makes imports cheaper, inducing a substitution in spending away from domestically produced manufactured goods to foreign-produced goods.

Third, overvaluation reduces the profitability of US manufacturing firms by making foreign goods cheaper, and this reduces firms' incentive to invest in new production capacity.

Fourth, by making US-based production relatively more expensive, an overvalued dollar gives US companies an incentive to shift production offshore and to build new production facilities offshore.

These negative effects on the trade deficit and manufacturing in turn adversely impact overall US economic growth. According to the Bureau of Economic Analysis, the US goods trade deficit lowered GDP growth by 0.09 percent in 2001, 0.71 percent in 2002, and 0.42 percent in 2003. The trade deficit therefore deepened the recession and is hampering the recovery.

The critical economic significance of exchange rates was summarized in the testimony before the Commission by Franklin J. Vargo: ''Only 11 percent of the cost of a US manufactured good is labor. If a product gets a 20- or 40-percent price advantage because of a currency, that is a much more significant factor.''

The reason is that currency misalignments work on the entire cost base, so that an overvalued currency raises the entire cost structure.

The Overvalued
Dollar And Undervalued Yuan

There is widespread agreement the dollar has been overvalued against the currencies of the world's major trading countries. With regard to China, the Commission heard testimony that the yuan is undervalued by between 15 and 40 percent. Based on this testimony and other economic evidence, the Commission believes that:
•    the yuan needs to be revalued substantially upward against the dollar;
•    as part of this revaluation, the yuan should be pegged against a trade-weighted basket of currencies to avoid excessive fluctuation against the currency of any single country;
•    China should refrain from adopting a floating exchange rate at this time, as its banking system and financial markets are not yet prepared for such an arrangement; and
•    China should take active steps to reform its banking system and financial markets to prepare them for an eventual floating exchange rate.


Case For Revaluing The Yuan

The dollar has now entered a period of correction against the currencies of other industrialized countries. As shown in [Figure 1], since January 2, 2002, it has fallen 33.3 percent against the euro, 16.4 percent against the yen, and 14.4 percent against the Canadian dollar. In addition, it has also fallen significantly against other currencies such as the pound sterling and the Australian dollar. However, there has been no adjustment against the Chinese yuan, which is fixed through official intervention. Additionally, there has been little in the way of correction against the Taiwanese, South Korean, and Singaporean currencies, all of which countries run large trade surpluses with the United States. This lack of adjustment has occurred despite the fact that there is compelling evidence that the yuan is undervalued. China now constitutes the single largest contributor to the US trade deficit, and economic fundamentals support the claim that the yuan is undervalued.

China's economy has been characterized by a trade surplus (external imbalance) and by rapid economic growth with incipient inflation (internal imbalance). A currency revaluation will help restore both trade balance and domestic economic balance by reducing exports and reducing demand for domestically produced goods.

Conversely, the US economy has a large trade deficit (external imbalance) and excess capacity and unemployment (domestic imbalance). Dollar devaluation will help restore both external and internal balance by increasing exports and demand for US-produced goods.A revaluation of the yuan is also needed for global economic equilibrium. As noted above, the United States has significant trade deficits with other East Asian economies, including Taiwan and South Korea. These economies are apprehensive about revaluing their currencies for fear that they will lose competitiveness relative to China.

A revaluation of the yuan would likely free this logjam, allowing these economies to revalue too, thereby smoothing and accelerating the process of dollar adjustment.

Additionally, failure to revalue China's currency while currencies of other major trading partners appreciate promises to cause economic disruption. This is because other economies - such as Japan and the euro area - are implicitly being forced to take on a larger burden of adjustment to correct the US trade deficit, while the country with the largest surplus (China) undertakes no adjustment.

Arguments Against Revaluing The Yuan

Some argue the yuan does not need to be revalued. The Commission rejects this position.

One argument is that revaluing the yuan could lead to a financial crisis in the Chinese banking system that ends up perversely generating a lower value of the yuan. The claim is that opening China's capital account and floating the yuan risks a massive exodus of Chinese savings that could trigger a domestic financial crisis and yuan depreciation. Thus, paradoxically, capital account liberalization and yuan floating could actually cause depreciation rather than appreciation.

However, this argument confuses revaluation of China's exchange rate with a shift to a floating exchange rate. The Commission does not recommend floating the yuan at this time. Instead, China should significantly revalue the yuan upward while maintaining capital controls and a fixed exchange rate over the near term. This would address the underlying balance of payments disequilibrium problem while avoiding financial crisis.

China has begun to recognize its problem of domestic financial fragility, but must now accelerate the process of remedying it. The fact that capital account opening could trigger a massive outflow of Chinese bank deposits reveals the inhospitable climate of Chinese financial markets for domestic wealth owners. China must therefore move to make its financial assets more attractive. The threat of domestic capital flight is not going to disappear. Indeed, it stands to grow in magnitude as Chinese household financial wealth grows with development and households in turn seek to diversify their portfolios internationally.

The bottom line is that China's domestic financial fragility does not justify an undervalued exchange rate that exports deflationary pressures and destroys US manufacturing jobs.

A second argument is there is no need to revalue, since market forces will force a revaluation despite the Chinese government's exchange rate intervention.

This argument is based on the discredited economic doctrine of monetarism. The claim is that China's persistent trade surplus forces its central bank to sell yuan and buy dollars to prevent appreciation and that this expands the money supply, which will in turn cause inflation that drives up Chinese prices. As a result, China will gradually become less competitive, while US manufacturing companies will become more competitive.

The above monetarist argument is flawed. First, even if the mechanism worked, there are long and unpredictable lags between expansion of the money supply and higher prices. In the meantime, American manufacturing firms may be compelled to close down, with consequent loss of jobs.

Second, Chinese monetary authorities can take measures to mitigate the effect of a rising money supply on prices. These include raising reserve requirements in the banking system and sterilizing the monetary expansion by selling bonds and thereby withdrawing money from circulation.

A third argument is that the China trade deficit is unrelated to the exchange rate and is the result of a shortage of US saving - principally the result of the large US government budget deficit.

The argument is the US economy is consuming in excess of what it can produce and has to import the balance. The Commission believes the United States must address its chronic budget deficits, but it rejects the notion that this obviates the need for China to address its currency undervaluation.

Contrary to the claims of the saving shortage hypothesis, the US economy currently has severe excess manufacturing capacity and is capable of producing significantly increased manufacturing output. A shortage of national savings is not the problem. The real problem is that the misaligned exchange rate results in US goods being too expensive relative to foreign goods. This drives down demand for US-produced output, and, over a more extended time period, contributes to the elimination of US manufacturing capacity and the creation of a structural trade deficit. Plant closures and the loss of well-paying jobs in turn undermine the tax base and contribute to state and local fiscal problems.

A fourth argument is that though the United States has a large trade deficit with China, China's overall trade surplus with the rest of the world has been much smaller, and in the first quarter of 2004 it registered a small deficit. Consequently, China's currency may not be undervalued.

Again, the Commission rejects this argument. [Figure 2] shows the United States has a trade deficit with every region of the world, and the deficit with China is especially large. This pattern points to a need for a generalized realignment of the dollar, and China should revalue its currency as part of that realignment.

Second, for the last several years, China has run a global trade surplus. Moreover, the fact that China has run a surplus even as it grew at 9 percent per annum is compelling evidence of undervaluation. Any other country that grew at that rate would have quickly run up a huge trade deficit. The small move into deficit in the first quarter of 2004 reflects continuing breakneck growth and rising commodity prices, particularly in oil. That China still essentially has balanced trade under these conditions is testimony to how undervalued the yuan is.

Finally, China is also running a capital account surplus generated by the flood of FDI into China. This means China has an enormous basic balance surplus, defined as the combined surplus on current and capital accounts. Thus, in 2003, China had a current account surplus of $45.9 billion and a capital account surplus of $52.7 billion, making for a basic balance of $98.6 billion. This put significant upward pressure on the exchange rate, but purchases of $116.8 billion of foreign exchange by China's central bank prevented the exchange rate from appreciating.

Editor’s Note: The US-China Economic and Security Review Commission’s Report to Congress is available in full at www.uscc.gov. Textile World wishes to thank Associate Director Kathleen J. Michels for permission to excerpt.

December 2004