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Analysing the debate over China’s exchange rate and the trade balance

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In Brief

In the debate on whether China should appreciate its currency or keep it stable as I argue, it’s worth going back to some basics to clear things up.

For a ‘home’ country, consider the identity from the national income accounts:

X - M = S - I = Trade (Saving) Surplus

where X is exports and M is imports (both broadly defined), and S is gross national saving and I is gross domestic investment.

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The left hand side of the identity suggests that a depreciation of the home currency will make exports cheaper in world markets, and they will expand. Similarly, the home country’s imports will become more expensive in domestic currency, so they should contract. Thus the conventional wisdom has it that the overall trade balance should improve if the underlying price elasticities are even moderately high. This seemingly plausible result is very intuitive, so even journalists can understand and perpetuate it.

But this ‘elasticities’ approach is basically microeconomic and quite deceptive. In this model, the export supply function is looked at on its own— and the demand for imports is looked at on its own—even by supposedly sophisticated econometricians who purport to measure separately the price elasticities of exports, and of imports, to exchange rate changes. Thus it is called the elasticities approach to the trade balance.

But if you analyse the right hand side (S – I) of the identity, the emphasis is macroeconomic. For the trade balance to improve with exchange depreciation, overall domestic expenditures must fall relative to aggregate output. After some minor algebraic manipulation, this is the same thing as saying that domestic saving must rise relative to domestic investment. Looked at this way, one cannot presume that domestic 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 RMB were to appreciate sharply against the dollar. This might set off a minor investment boom in the US where expenditures rise, and a major slump in China’s huge investment sector, so that expenditures fall, the economy slumps, and imports contract. This is what happened to Japan in the 1980s into the mid-1990s when the yen went ever higher. Japan became a higher-cost place in which to invest, large Japanese firms decamped to invest in lower cost Asian countries, and in the US itself. The trade surplus of the slumping Japanese economy increased!

No wonder China is reluctant to appreciate!  Like Japan, its trade (saving) surplus would likely not diminish and foreigners, in the US and Europe with the misleading elasticities model in their heads, would come back and say ‘you just didn’t appreciate enough’. With this adverse expectation of continued appreciation, the upshot would be further hot money inflows, a bigger build up of dollar foreign exchange reserves, and a potential loss of internal monetary control.

Ronald I. McKinnon is the William D. Eberle Professor of International Economics at
Stanford University.

One response to “Analysing the debate over China’s exchange rate and the trade balance”

  1. While I am sympathetic to the author’s view that currency appreciation may not be sufficient to reduce the trade surplus, I kind of feel that he cheated: The so-called ‘macroeconomic analysis’ he introduced in the post looks to me as only a special case. Currency appreciation leading to the collapse of investment and imports only happens with special conditions.

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