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Krugman’s Chinese renminbi fallacy

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In Brief

Paul Krugman is one of the international economists I most respect. He is a towering figure in the study of international trade. But his understanding of some international economic policy issues is, to put it generously, naïve. In fact, were the Obama administration to follow his policy advice, the world economy could encounter more serious difficulties, if not another recession, in the years ahead.

In the year 2010, Krugman suddenly found a new and passionate interest in China’s exchange rate policy.

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On 1 January, in his piece ‘Chinese New Year’, Krugman claimed that America had lost 1.4 million jobs because of the undervalued renminbi and, therefore, he endorsed trade protectionism against China. On 11 March, in another piece, ‘China’s swan song’, he advised the Treasury Department to name China as a currency manipulator. And on 12 March, at an Economic Policy Institute event, in Washington, he said that global economic growth would be about 1.5 percentage points higher if China stopped restraining the value of its currency and running a trade surplus.

Most economists would agree with Krugman that the renminbi is probably undervalued. But the extent of misalignment remains a controversial subject. For instance, applying purchasing power parity (PPP) approach, Menzie Chinn of University of Wisconsin, Madison, and his collaborators used to discover undervaluation of about 40 per cent. But after the World Bank’s 40 per cent downward revision of Chinese GDP in PPP terms, that undervaluation disappeared completely. Nick Lardy and Morris Goldstein of the Peterson Institute of International Economics suggested that renminbi was probably only undervalued by 12-16 per cent at the end of 2008. My colleague Yang Yao and his collaborator at the Peking University found even less misalignment.

The renminbi exchange rate is but one, and perhaps not even the most important, factor behind China’s large trade and current account surpluses. Among other factors, economic studies have attributed the recent surge in China’s external imbalances to the unique population dividend and the relocation of industries from other Asian economies. My own research has also highlighted the importance of distortions in domestic factor markets, which were largely legacies of the pre-reform economic systems of central planning.

To resolve the global imbalance problem, China, US and other countries will need to work together and adopt more comprehensive reform packages, focusing not only on the exchange rate regime but also on domestic structural reforms in their respective countries. Exclusive focus on the renminbi exchange rate issue is likely to be both ineffective and counter-productive. Between mid-2005 and mid-2008, the renminbi appreciated by 22 per cent against US dollar and by 16 per cent in real effective terms. But China’s external imbalances continued to widen rapidly.

The US started to lose manufacturing jobs way before China emerged as a global manufacturing centre. China’s current account surplus increased after 2004. But America’s current account deficits mushroomed from around the turn of the century. There is no denying that China and the US should work together to resolve the imbalance problem. But to say that China’s surplus caused America’s deficits, which emerged much earlier, is simply at odds with common sense.

So what would happen were the Obama administration to follow Krugman’s advice? First of all, it would delay, not accelerate China’s exchange rate policy reform. On 6 March, the People’s Bank of China (PBOC) Governor Zhou Xiaochuan made it clear that the current soft peg of renminbi to the US dollar was a temporary response to the global financial crisis and that this would have to end. These statements clearly suggest that the Chinese authorities are searching for an appropriate time for exit from the soft peg and I think this could happen any moment from now.

But finding the appropriate time is not always easy. The China-US policy game on renminbi exchange rate can be best characterised as a ‘prisoners’ dilemma’. It is important to keep in mind that, like American politicians, Chinese leaders also have to entertain domestic political pressure. And to be seen as giving in to American pressure can substantially weaken the leaders’ political standing and capacity to act in everyone’s best interests. China is more likely to move ahead quickly if the US maintains a calm and rational stance. This was largely what happened in the lead up to the July 2005 exchange rate reform.

But the prisoners’ dilemma arises here. American politicians and commentators will not want to keep quiet since that will lose them the opportunity to take political credit, even if China liberalises the exchange rate policy. In fact, some American politicians may be secretly hoping that China does not do anything. Many of them understand perfectly well that revaluation of renminbi will not bring jobs back to the US If that happens, then they will have to find a new scapegoat for the double digit unemployment problem. In the meantime, the Chinese government is reluctant to make any significant change under foreign pressure. This is why Krugman’s intervention only makes things worse.

Let’s imagine some scenarios in which Krugman gets what he asks for: the US Treasury Department names China as a currency manipulator and the Obama administration launches trade war against China. If this were to happen, the most likely scenario is that China would then stick to its current exchange rate regime and retaliate with trade sanctions against America. This would reduce trade between the two countries but, more importantly, seriously damage investor confidence worldwide. Trade war between the two largest economies is a non-trivial event for the world economy. In face of much more uncertain economic future, investors would scale back their investment plans and consumers would cut back their spending.

A less likely scenario is that China would be forced to appreciate the currency sharply by, say, 40 per cent. This is likely to cause significant difficulties for Chinese companies if the exchange rate adjustment were forced abruptly. Again, there could be two possible outcomes. The first is that Chinese companies would no longer be able to export because of sudden loss of competitiveness. The market vacuum newly made available by exit of Chinese products would be taken up by products from other low-cost countries like Vietnam and India. American companies would not be able to compete with these countries. So this would not add new jobs in the US, but the inflation rate would move higher.

Since exports account for more than one-third of the Chinese economy, collapse of exports would cause serious difficulties for China. Chinese growth would decelerate sharply, as happened in late 2008. This would be unfortunate since most major economies are still struggling with recovery. And sudden weakening of the world’s most dynamic economy would send chilling messages across the world markets. Investor confidence would again fall sharply.

The second possible outcome is that China would continue to export to the US market, at higher prices but lower profits. This would push up inflation rates significantly in the US and force the Fed to tighten monetary policy quickly. Both steps could hurt the momentum of America’s recovery, which is still not yet on steady footing. New difficulties in the US and China, the two largest economies of the world, would impact global investor confidence negatively.

In either case, global economic growth would be about 1.5 percentage points lower, not higher, if China revalued the currency as Krugman demands. The magnitude is probably exaggerated, but the direction is certain.

Yiping Huang is professor of economics at the China Center for Economic Research at Peking University and in the Crawford School of Economics and Government in the ANU.

7 responses to “Krugman’s Chinese renminbi fallacy”

  1. I agree with almost everything in this article, and particularly with its central argument that revaluation of the RMB is only one of a wide range of measures that need to be taken in order to reduce China’s large current account surplus. Ultimately, its persistence is due not to large exports to the country’s large excess savings. Much of the evidence suggests that these are due, not to frugal households, but to savings by government and corporates. As long as these domestic imbalances continue, so will the external ones.

    That said, I am doubtful that a 40 per cent revaluation would be anything like as damaging to China’s exports and growth as Yiping Huang suggests. Exports do not, as he states, account for a third of China’s GDP. This is a common misconception that arises from comparing apples with pears. Exports are gross sales; GDP is value-added.

    In 2007, their peak year, exports’ true contribution was probably around 18 per cent of GDP and 20-25 per cent of growth. That is because so many of China’s exports are still “processing trade” and involve the final assembly of imported components into finished products. The local value-added from such activity is often very low, particularly in electronics products, one of the fastest-growing export sectors, where it is as little as 15 per cent. As a result, much or most of the impact of a revaluation on export prices would be offset by a decline in import prices in local currency terms. Furthermore, Chinese manufacturing has exhibited impressive sustained productivity gains, which are likely further to soften the impact of a revaluation.

    In reality, exports and the exchange rate are not primarily an economic issue in China: they are much more a political one. They generate a lot of jobs in prosperous and politically powerful coastal provinces which have strong voices in Beijing and are obviously keen to avoid any threat to their well-being. That is what the increasingly obvious in-fighting about the exchange rate is really about.

    Finally, casting the debate purely in terms of revaluation is missing the main point. What really matters, or should matter, is not the “correct” level of the exchange rate (which is anyone’s guess); It is the cumbersome mechanism used to maintain it, which involves massive intervention at huge cost to the economy and the financial system. For an admirably clear explanation, see Nick Lardy’s paper on financial repression in China, available on the PIIE website. That is what China’s foreign critics should have in their sights.

  2. For Krugman to have engendered such an ardent response, there must be something more than the issue of the nominal exchange rate than just its economic consequences. My fear is that the nominal exchange rate policy is increasingly a badge of national honor in China rather than a useful policy tool and a symbol of national shame in the US.

    If that’s the case, the argument for reaching an accommodation on the issue so as to safeguard a broader relationship is huge. Nationalismis is intolerant and irrational. If it comes to dominate discussions, China, the US and the world will suffer.

    Of course there are myriad reasons for the persistence of China’s trade surplus, and, yes, US manufacturing jobs were lost for reasons that go beyond the nominal value of the yuan. But, neither of these conditions is an argument for maintaining a fixed exchange rate. They simply imply that the consequences of altering the exchange rate will be lower than some assume.

    There are two reasons for China to return to the limited fx flexibility it adopted in 2005. The first is internal, the second external.

    As Krugman points out, China has both a trade surplus (yes, a smaller one than in 2008, but one that is forecast to grow as a share of GDP this year) and rising inflation (by my calculations inflation is running above the newly announced 3% target for this year). Why? Because real demand is rising too rapidly–11% in Q4 according to the People’s Bank, a rate that exceeds the estimates of sustainable growth for China I’m aware of. And because the real exchange rate, inclusive of factor price and structural distortions is undervalued.

    China has a choice–allow the higher inflation to erode both the real exchange rate and real demand–or appreciate the nominal exchange rate and tighten fiscal and monetary policy. It’s already doing the latter two. Why not the first?

    The failure to allow some of the real exchange rate adjustment to come through the nominal exchange rate looks lamentable in the face of the second reason for acting: the growing chorus of calls for adjustment coming from trading partners. Some of those calls would still were China to step back a bit from its de facto exchange rate peg.

    Paul Krugman is calling for the US to name China a manipulator to force up the costs to China of maintaining that peg. He says explicitly that he sees the chances of a trade war as low. Yiping Huang’s response is that China will retaliate by becoming more recalcitrant. That doesn’t fit well into a cool assessment of costs and benefits. It smacks of petulant nationalismon China’s part.

    Or of clever gamesmanship. Threatening to do something that is against your own interests–as perpetuating a trade war with a country with which you have a trade surplus clearly is–only makes sense if the other side views you as sufficiently irrational so as to actually carry out your threat.

    But isn’t a trade war a cost to the US, too, and, therefore, not a credible threat unless the US, too, is irrational? Not, if officials believe that on the margin China’s threat to dump US Treasuries is blunted by the liquidity trap and that the surfeit of underutilized resources in the US will allow domestic production to substitute more easily for Chinese imports than would be the case in normal times.

    So for China, the obvious question is why risk all this external opprobrium when domestic conditions warrant a change? Why not step back a bit from the exchange rate, putting more of it’s movement in the markets hands?

    Nationalists on both sides of the Pacific would then have to blame the exchange rate on the market. One thing about the market, though, it’s not prideful or nationalistic!

  3. Krugman is good and famous at the so called strategic trade. Now he has found an occasion to apply his theories at the world scale.

    When I heard or read about Krugman’s talking about the Chinese currency versus the $US, I have always been reminded by a remark by Frank Milne (hope it is correct) once at his lecture of microeconomics at the graduate/masters level: economic policies can kill at a mass scale – look at what happened in China during the great leap forward and how many people died as a consequence!

    Now Krugman, a winner of the Nobel Prize in Economics, is making his prescriptions to real economic problems and doing his economic advices to the US and possibly to some others.

    It will be interesting to anticipate what his advices will result in, even for the Americans whom he tries or intends or has said or is said to help.

  4. I am glad Yiping Huang is counselling against Krugman’s unhelpful advice.

    I welcome the comments by Don Hanna. He notes the need to find an intelligent way out of the policy problem. It in NOT a prisoner’s dilemma (which has some quite specific characteristics that do not apply here). Communications and rationality do provide a way out along the lines Hanna suggests, provided national pride is not given undue weight in the calculations of costs and benefits.

    I also agree with Guy de Jonquieres about the limited effect of exchange rates on the price of exports with a high import content.

  5. A few issues to consider:

    1. The US external deficit, is the US having external trade deficit with China? Or is China the largest and for how long it has been as the largest?

    2. If China is currency manipulator then it must have devalued its currency against the $US which its currency pegs into. Has China devalued its currency in recent years? Against the $US?

    3. Isn’t the US a currency manipulator? Haven’t we often heard the US authorities say or have said that they want or wanted strong or weak $US? What do they mean or have they meant? Not a currency manipulator?

    4. PPP and currency valuation: it is a general knowledge that most developing countries’ GDP is higher in PPP, as opposed to their market currency. Does it mean their currency is undervalued in market terms?

    5. The US has been blaming others for its external deficits, that is because they trade with others. Who should it blame for its out of control budget deficits?

    6. Why balances, as opposed to imbalances should be the norm? Just think about savings and borrowings, consumptions and investments, why should any unit except the world as a whole be always balanced at all time? Is that good or bad for the living standards and welfares of the world?

    7. Why does the US argues for free trade sometimes and say a different thing some other times? Isn’t it political economy at the world scale?

    8. Why has the US had the lowest and sometimes negative saving rate? Did any other countries force it to do that? Whose fault is it?

  6. Thanks for your comments, everybody. I am at the airport and so will be very brief.

    I want to make two quick comments other than saying thanks for sharing your insights.

    First, I have to admit that citing the export share of GDP is not exactly a scientific approach, as Guy de Jonquieres pointed out. This, however, is a common measure for openness in trade and policy literature. While exports are not all value-added, its share of GDP does show the degree at which the economy is exposed to the outside world.

    Second, I always admire Don Hanna’s calm analysis, even at crisis times. I take everything said on why China should appreciate the currency, which is the case I always make in China whenever possible. However, I think wars or trade wars happen often not as a result of calculation by rational people. I am sure Chinese officials are considering all options. But if the Treasury names China a currency manipulator and the Obama administration starts some sort of protectionism measures, I don’t think the Chinese officials have much of a choice. This is why I think Krugman’s comments are not helpful (though his suggestion that renminbi should appreciation is valid).

    As we all know perfectly well, future developments will be dependent on politics as much as on economics. I am sure the officials at the PBOC and Treasury share some common analyses of the issue. But politics is simply beyond their control on both sides of the Pacific.

    Enjoy debating!

  7. I think this article has generated useful and interesting debates. Some of those are related to conventional wisdoms of economic theories.
    For example, the point made by some about China’s exchange rate regime is implicitly based on the assumption that a flexible exchange rate regime is superior or better, so China should move to that or restore that mechanism.
    The implicit problem with some of conventional economic theories that most people accept or use as truth nothing but the whole truth can be very inappropriate and indeed very dangerous at times. Further, it is often ignored by many people that the whole context of a particular regime is operating.
    Undoubtedly, many if not most economists would probably assume that the flexible regime is better. What about Japan’s lost decade of the 1990s? Was Japan using a flexible or fixed exchange rate regime? Did it help Japan? Or from another viewpoint, did it solve Japan’s trade surplus, or for that matter the US trade deficits? I assume they both had a flexible exchange rate regime when very large trade imbalances could still have occurred.
    Another point, while a flexible exchange rate regime is said to allow the monetary authority to pursue a free monetary policy of its own. However, we have seen wild fluctuations in some exchange rates, say even the $US and the Euro, for example. Do those wild fluctuations in exchange rates not have a destructive effect on the economies or businesses? When people talk about the freedom of monetary policies, did they have an idea of the potential costs to businesses or the economies in mind? Have they done a cost and benefit analysis as such?
    Further, many economists have been talking about allowing currency to appreciate and its effect to dampen inflation. I am not arguing they are wrong. But have they thought about how the Chinese monetary authority conducts its monetary policies and how that can deal with a fixed exchange rate regime and effective monetary policies?
    Do many economists really have rational expectations, in the sense that they have a correct model of the real economies and how they work?
    I have no answers to that, but sometimes it pays to be a little suspicious, or a bit diligent, and not be blind-sided and simple accepting what some people are saying, no matter how elegant they may be. After all, history has proved that many people can be wrong, and sometimes seriously wrong, in both their theories and their beliefs.
    The fact that there are serious disagreements among the best minds and most bright and great economists on so many issues is proof that a particular economic theory or conventional economic wisdom is not necessarily always sacrosanct. It can be dangerous to use them mechanically.
    To me, that acts as simple risk management.

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