Understanding China’s Currency Apprehensions
Debate over China’s exchange rate policies vis-à-vis the US dollar is usually structured in terms of trade imbalances: U.S. overconsumption and a zero savings rate on one side, and Chinese high savings and overproduction on the other. While the focus in the West is primarily on short-term appreciation of the Yuan (RMB), the inclination in China seems to be on longer-term structural reform.
It is important to understand why China uses a fixed exchange rate and an independent monetary policy to keep the value of the RMB low in relation to the U.S. dollar. A lower RMB keeps the prices of Chinese-made goods competitive globally. In exchange for these goods, China continues to accumulate savings through foreign financial assets such as U.S. treasury bills (currently totaling $2.2T).
China’s approach to the exchange rate issue has been to focus on inflation first and currency manipulation second. China views its dollar peg with the U.S. as crucial for its trade and investment flows.
China views its dollar peg with the U.S. as crucial for its trade and investment flows.
It fears that ending its dollar peg would bring about financial instabilities: speculative capital inflows, asset bubbles, and short-term shocks to businesses. Politically, the argument can also be made that by continuing to bolster employment, productivity gains, and wage growth, China is limiting domestic social conflict.
Arguments from the U.S. for a quick rise of the RMB are rooted in concerns about China’s large current account surplus, high growth, rapid urbanization and industrialization, low national debt, and low fiscal deficits. The U.S. recognizes the need for Chinese private sector consumption to fuel more of China’s economy. Pre-2008 U.S. consumption was unsustainable, and the Chinese private sector will have to pick up some of the slack going forward.
China’s high savings rate (estimated at 55 percent of GDP) is often attributed to lack of adequate healthcare and the lack of a social safety net. But this is only half of the story. State-owned enterprises (SOEs) have traditionally been unable to pay high wages or distribute dividends. Thus the high savings of these enterprises have instead been invested in overcapacity sectors. Thus continued privatization of SOEs, in conjunction with better health care and social security systems, will be important to releasing the savings necessary to fuel internal consumption.
The RMB should rise eventually, but the U.S. and China cannot agree on the pace. The U.S. would like significant appreciation quickly in order to impact the U.S.’s current account deficit in the short term. The Chinese, remembering the lessons of Japan in the 1980s, are calling for a longer-term strategy that will mitigate growth disruption and destabilization.
In Japan’s case, rapid currency appreciation created massive asset bubbles that eventually burst,
…In Japan’s case, rapid currency appreciation created massive asset bubbles that eventually burst
leading to nearly two decades of deflation without eliminating its trade surplus with the U.S. China is worried that a floating RMB will lead to analogous economic woes, speculation and asset bubbles.
In truth, the cases of Japan and China are not as similar as they appear. However, there is one important lesson that China can learn from Japan’s experience. Resisting currency appreciation for too long can cause extreme volatility and market destabilization. Japan had resisted upwards movement of the yen for so long that when it was finally allowed to appreciate, the result was a violent bursting of the bubble economy and two decades of subsequent deflation.
One of the best reasons to allow RMB appreciation is to prevent the Chinese economy from overheating. 2010 GDP forecasts already project growth at nearly 12 percent. The Chinese government would be wise to allow the RMB to rise consistently in relation with productivity gains to keep domestic growth in check, rather than risk sharper spikes later as the gap between inflation and productivity widens.
Overall rebalancing of the world economy without major dislocations will be best accomplished through difficult structural reforms in both the U.S. and China. Higher inflation in China and lower inflation in the U.S. could help, but this requires a stronger dollar. To that end, interest rates in the U.S. will have to rise, deleveraging will have to occur, and U.S. fiscal debt will have to be reduced. China will have to continue to privatize SOEs, develop policies and infrastructure to address health and social security, and keep credit under control while continuing to develop its rural areas.
