There are some suggestions in the market that the RMB might take another one-step appreciation, like what happened on July 21, 2005, but I think this is highly unlikely.
China probably missed a good opportunity to exit from the soft peg exchange rate policy in late 2009, when growth accelerated, trade recovered, inflation returned. But it is not too late to do it now. After all, greater exchange rate flexibility is in China’s own interest. It can help stem budding inflationary pressure, improve economic efficiency, balance the economy and reduce unnecessarily external tensions.
But this issue of RMB exchange rate policy will not disappear from international economic policy debate any time soon. As long as the US still has an unemployment problem, the global economy remains imbalanced and RMB exchange rate stays short of free float, the argument between the two largest economies of the world, the US and China, will likely continue.
It is natural that the international policy debate about RMB exchange rate policy has an important political dimension, demonstrated by the political motivations of some American politicians and sentiments of nationalism among some Chinese scholars. Even at the professional level, misperceptions of the RMB exchange rate policy are common on both sides of the policy debate. Clearing up these misperceptions is vitally important.
Let’s briefly examine some common misperceptions.
‘China manipulates its exchange rate policy’
This argument is widely accepted in the west, but the legal basis for this argument is unclear. What China adopted was fixed exchange rate policy in 1997-2005, a managed float in 2005-2008 and a soft peg after 2008. True, the People’s Bank of China intervenes in the foreign exchange markets by purchasing USD in order to maintain stable exchange rate for the RMB. But does this amount to ‘currency manipulation’?
A fixed exchange rate was the dominant regime under the Bretton Woods System (BWS), when the USD was pegged to gold and all other currencies pegged to the USD. After President Nixon de-linked the USD from gold in 1971, the IMF started to encourage more flexible exchange rates from 1973. But the IMF never introduced any rules prohibiting any country adopting a fixed exchange rate. In Asia, Hong Kong has a currency board arrangement and Singapore has a crawling peg. Neither the US nor IMF appears to have any problem with these two economies.
‘Appreciation of RMB would help rebalance the global economy’
Given its important role in global imbalances, China will have to work with others to reduce the imbalance problem. And RMB exchange rate policy should be a critical part of that effort. But successful resolution of the problem will require comprehensive policy packages on both sides of the Pacific. Exclusive focus on the exchange rate issue is likely to be both ineffective and counter-productive. For instance, savings behaviour has to change in both the US and China, alongside introduction of more flexible exchange rate regimes.
Between mid-2005 and mid-2008, RMB appreciated by 22 per cent against USD and by 16 per cent on real effective terms. But China’s current account surpluses rose from 3.5 percent of GDP in 2004 to 10.8 per cent in 2007, before moderating to 9.6 per cent of GDP in 2008 due to global recession. In March 2010, China suddenly recorded a trade deficit of $7.2 billion, despite continuation of RMB’s soft peg to USD. Clearly, there are other factors, alongside the currency, affecting China’s external imbalances.
‘Currency appreciation is bad for the economy’
The idea that currency appreciation is bad for the economy is perhaps an unspoken but widely held belief in some sectors of the Chinese society, especially among non-economists. It may be related to the current government’s over-emphasis of GDP growth. A stronger currency normally slows export growth. Currency appreciation, as long as it is determined by improvement in economic fundamentals, should be positive for the economy. It helps to promote industrial upgrading, achieve structural balance and even increase residents’ purchasing power. It often speeds up the process of catching up with advanced economies.
Wrong lessons drawn from the Japanese experience of the Plaza Accord also play an important part in the widespread fear of currency appreciation in China. In fact, the popular perception that yen appreciation in the late 1980s contributed to Japan’s lost decade in the 1990s is inaccurate. The causes of growth stagnation in Japan were much wider, including problems in corporate governance, a rigid labour market, inappropriate monetary policies, and the building and bursting of asset bubbles. In a way, Japan’s resistance to currency appreciation also contributed to drastic adjustment later.
‘RMB exchange rate is China’s domestic policy issue’
Theoretically this may be true. Only the Chinese government can decide on RMB exchange rate policy. And it does so according to China’s own interest. But in a globalised economy, it’s natural that any country’s exchange rate policy faces a reaction function in the other countries. It is important to remember that China is already a large country, defined in economics terms not only in terms of population or geography. Any changes in a large country naturally cause significant adjustments in the world markets.
Taking into account other countries’ responses, however, does not imply that the Chinese government acts against its own interest. For instance, having a trade war with a major trading partner is not in a country’s own interest. But, of course, the Chinese government’s decision has to balance domestic and external factors. The choice of exchange rate policy should also be favorable to achieving macroeconomic stability. Nationalism is tempting in international policy debate, but it often is harmful for long-term economic interest.
‘The exchange rate is not a price variable and should be fixed for stability’
This view is popular among some Chinese scholars. This is unfortunate, but it is not unique. People always find reasons to argue that certain prices, such as the rice price, water price or gas price, are not normal prices and therefore should be treated differently. But that is only partly true. The rice price may be a special price. But that does not mean market mechanisms should be restricted for rice. The exchange rate and interest rate are prices of capital. Market mechanisms for these rates are critical for achieving efficiency of capital use.
More importantly, the well-known trilemma theory dictates that a country can only achieve two of the following three policy objectives: monetary policy independence, the free flow of capital and exchange rate stability. Hong Kong operates a currency board system successfully because it gives up monetary policy independence. China, as a large and dynamic economy, cannot afford to forego monetary policy independence. Recent evidence also suggests that capital account controls have become less effective. Therefore, a fixed exchange rate may no longer be a viable option for China any more.
‘China can achieve real appreciation through inflation’
This argument is valid, at least theoretically and to certain extent. In the end, what counts is real appreciation. And real appreciation can be realised through either nominal appreciation of the currency or high inflation. But in reality, it might not be feasible. Price movements often delay. Otherwise we should have not observed so much currency misalignments around the world. In addition, China still does not have a sound and transparent framework for monetary policy. Once inflation gathers momentum, it might be difficult to arrest.
And political consequences of high inflation are much more serious than nominal appreciation. Inflation normally discriminates against low-income households and is often an important threat to social stability. For instance, high inflation in 1988 led to major social instability in the following year. This is why the Chinese authorities have shown high sensitivity to inflation. And the US sub-prime crisis also suggests that high inflation in the form of asset bubbles can be even more disastrous.
‘RMB appreciation by 3-5 per cent could seriously hurt the export sector’
Chinese government officials undertook some pressure tests recently and concluded that even modest currency appreciation could significantly affect export performance. This is probably true. Appreciation of the currency squeezes profit margin of exports and hurt some exporters. But is it necessarily a bad thing? If these exporters could only survive on an undervalued currency, then they should have been phased out anyway. Currency appreciation driven by improvement in economic fundamentals is an important path to industrial upgrading.
‘Static’ pressure tests often also overstate the negative impacts. In the real world, entrepreneurs can respond positively under pressure. Again, between 2005 and 2008, despite nominal exchange rate appreciation, export growth did not slow at all. On the contrary, China’s trade surplus widened rapidly.
‘One-step adjustment is the best way to appreciate the currency’
A key argument supporting one-step adjustment is that gradual appreciation often attracts more ‘hot money’ inflows. However, finding the right magnitude of this ‘one-step’ is exceedingly difficult. A step too small is likely to encourage expectations of further appreciation. But a step too large could seriously hurt the real economy in the short term. It is beyond policymakers’ capability in defining the ‘optimal’ step.
Moreover, one-step adjustment is also against China’s long-term reform goal – to improve the exchange rate formation mechanism based on the forces of demand and supply. For this purpose, an increase in exchange rate flexibility is to be preferred over one-step adjustment. ‘Hot money’ flows are a headache. But in today’s world it is no longer possible to completely stamp out such flows. The aim should therefore be to encourage domestic companies and financial institutions to learn to cope with capital flows, through use of hedging instruments.
Yiping Huang is Professor of Economics at the China Center for Economic Research of the Peking University and at the Crawford School of Economics and Government of the Australian National University.
Yiping has discussed a number of issues related to the Chinese exchange rate that may go beyond my capacity to comment.
However, I would like to raise an issue on one of the points that is the impact of an appreciation on China’s huge unemployment or hidden unemployment.
As we all know, China’s rural population share is high, or in another word, its urbanisation is low. As a result of its economic reforms, some rural labour has become mobile workforce. But addmittingly, there are still huge numbers of rural workers who are surplus to rural needs and are the hidden unemployed, due to the very limited and low land per capita and mechanisation in rural production.
That has always been why most mobile rural workers are not paid much and kept the Chinese products competitive internationally.
Further, it has been reported that there are seemingly shortage of mobile workers from rural areas in some big manufacturing areas. While seemingly contradictory to the hidden unemployment still existing in rural areas, it is a sign that the costs of labour will rise soon.
On top of that, the recent trade figures already show a trade deficit for China.
So it is difficult to understand why the Chinese currency should or would appreciate and its economic rationale.
It seems many analyses are based on political pressure. Alternatively, they may have been based on some prevailing views.
But the GFC has shown that some prevailing views or consensus are not necessarily always correct.
There are a number of points relevant but missing in Yiping’s analysis.
Firstly, the impact on employment of appreciation, especially on mobile workers from rural areas and associated social stability must be carefully analysed and considered. This, of course is what the authority has to consider when large scale closures of manufacturing plants as a consequence of currency appreciation are concerned.
It is not just an issue static versus dynamic adjustment issue, although it has some relevance. Any dynamic adjustment has to be realistic as opposed economists’ wishes for a sudden technical or management improvement. For economists, it is so easy to change the ratio of labour versus capital and adopt new technologies. But in reality, the story can be quite different. Managers and entrepreneurs are not as lazy as some economists think.
Secondly, the issue of China’s official reserves and assets denominated in $US and its potential very damaging consequences in terms of social stability, given that now many Chinese are aware the effects of a yuan appreciation. It is obvious to so many Chinese, especially the so called elite what an appreciation means in terms of the values of those assets. It is, however, very difficult to judge the how the public will react to authority sanctioned appreciation and the losses in state assets values.
Thirdly, even China adopted a flexible exchange rate, there is no guarantee that the US or some others continue to pressure China. For example, they could and would argue that it is not flexible enough as long as they wish to use it as stick to achieve whatever purpose they may have. At some stage, a country has to stand up to powerful countries for its own interests, otherwise international bullies will repeat endlessly with no real prospect to be checked.
Fourthly, the argument of country can only achieve two out three goals of “monetary policy independence, the free flow of capital and exchange rate stability” is likely to be problematic, if bank credits can be controlled. It is more than likely that in China’s case, all three can be achieved, rather than the conventional view.
Fifthly, although Yiping used some of the key insights (the unholy trinity) from the Mundell-Fleming model of international trade, an important implication of the model is overlooked, that is, the differential growth in domestic income as compared to external income. That should mean a deterioration of the current account balance. The experience of the past months indicates that has been the case now and further and possibly increasing trade deficits are likely to occur.
It would be prudent for both China and the US and other players to wait and assess the development in recent months before making any unwise moves. The Chinese economy is at a critical stage of structural transformation and in the short term it is highly likely to experience current account deficits until the transformation is completed.
Yes, China may move back to pegging to a basket of currencies and allows reasonable flexibility, but it does not necessarily mean currency appreciation measured by trade weighting.
Now it leads to ma last point on the missing elements in Yiping’s article, that is, the issue of China’s official holdings of $US denominated assets, that so many analysts have either ignored or think difficult to deal with. It should be clear that it is reasonable for the Chinese authority to negotiate with the US authority on the issue of Chinese holdings of the US Treasury bonds. In fact it would be negligent of duty if the Chinese authority does not deal with this issue. Some move on that front is necessary for the Chinese authority to be able to tell its domestic audience on any currency moves.
It is unreasonable and indeed irrational for the US to ask for China to appreciate its currency and make a direct loss by holding the US government bonds. That will make the Chinese authority look so stupid.
A reasonable compromise is to use a mixed currency denomination, e.g. denominated in a basket of currencies.