In testimony before the U.S. House of Representatives in March, C. Fred Bergsten, director of the Peterson Institute for International Economics (PIIE), a Washington, D.C.-based think tank, blamed the “severe” undervaluation of China’s currency — by as much as 40% against the dollar — for major job losses in the U.S. and global trade imbalances. He also laid out an action plan, including enlisting a multilateral coalition of countries for help or even slapping tariffs on Chinese goods, if China did not relax its tight currency control and allow the renminbi (RMB) to gain strength. “The case for a substantial increase in the value of the renminbi is thus clear and overwhelming,” he said. “An appreciation of 25% to 40% is needed to cut China’s global [account] surplus even to 3% to 4% of its GDP. This realignment would produce a reduction of $100 billion to $150 billion in the annual U.S. current account deficit.”
On June 19, the People’s Bank of China, the country’s central bank, obliged — at least in part. It announced that it will indeed abandon the two-year-old peg that has kept the RMB tied to the dollar and allow the RMB to respond more naturally to supply-and-demand forces. Effective immediately, it said the country would begin moving to a floating exchange rate regime, although a very tightly managed one, similar to what it used between 2005 and 2008, basing the RMB’s value on a basket of currencies, rather than just the dollar, within a very narrow band upward or downward.
But then came the news the next day that dashed the hopes of many China watchers: Its policy makers have insisted that any appreciation they allow to the RMB, which has been pegged at 6.83 to the dollar since July 2008, will be “gradual.” Analysts have interpreted that as only a few percentage points a year.
Relaxing its RMB policy “is kind of a convenience for China,” says Kent Smetters, a Wharton professor of insurance and risk management. “It’s not going to make that much of a difference for them right now. The demand for dollars is still going to be high and they can come across as being the good guys, but it’s not really costing them that much right now.”
Unveiled a week before the G20 meeting in Toronto and amid campaigning for various state elections in the U.S., the decision was indeed a nod to China’s global trading partners. International pressure had been intensifying to get policy makers to address what China-policy critics call “currency manipulation” — unacceptable to the International Monetary Fund and other multilateral organizations — as well as China’s seemingly unending appetite to buy U.S. dollars with cheap RMB for its stockpile of foreign reserves.
Yet regardless of the amount that the RMB appreciates — or depreciates — China’s decision is important, not only in debates about the future clout of the dollar and the RMB in global trade and politics, but also for correcting global economic imbalances, experts say.
No Shock Therapy
Against this backdrop, “it is quite understandable why [China is] returning to this managed floating exchange system,” says Wang Jianmao, economics professor and associate dean at the China Europe International Business School (CEIBS) in Shanghai. “We will try some small steps and wait to see what the outcome will be. I’m not expecting any [sort of] shock therapy or that kind of thing in China, no matter what the external pressure is.”
According to Wang, lessons from the past at home and elsewhere explain why China is taking this approach. Consider the Japanese yen. With a long undervalued currency and an export-dependent economy that boomed through the 1970s and mid-1980s — much like present day China — “the Japanese tried to delay the appreciation of their currency, and in the end they had to adjust the exchange rate under U.S. pressure too quickly,” he says. After Japan agreed to the Plaza Accord of 1985, which depreciated the dollar against the yen and Germany’s deutsche mark, the yen surged ahead, eventually leaving the country to face an asset price bubble that was bound to burst dramatically.
Then there are the lessons at home. “Since 2005, we’ve accumulated a lot of knowledge about our own experiences with currency revaluations,” says Wang. “We realize that in the later years — 2007 and 2008 — the speed of the [RMB's] depreciation may have been a little too fast.” A gradual appreciation “does not necessarily mean a slow one-way movement,” he adds. “There will be ups and downs, yet the overall trend will be upwards.” A “one-way bet” on RMB appreciation may have a downside as well as an upside if investors (including speculators) rush into China, but Wang predicts that any flow of hot money would be “manageable,” particularly if a capital gains tax is introduced. Furthermore, “it may be the case that gradual appreciation makes the holding of RMB as a reserve currency attractive, even though the investment opportunities of RMB are still very limited.”
The latter is a scenario that Franklin Allen, a Wharton finance professor, welcomes. “In the next 10 to 15 years, China needs to make the RMB fully convertible and have it become a reserve currency,” he says. “The real problem in the international architecture, since all the problems with the euro began, is that the dollar has become the only reserve currency, when we need three [currencies] to represent three regions. It may be better to have more, but three would be a good start.”
However, there’s a more pressing issue for China’s government: The impact of the revaluation on its vast foreign exchange reserves, 70% of which are said to be in dollars. “Much of these reserves are financed with debt in RMB. So if the RMB appreciates, they are effectively losing out,” says Allen. Any movement — even a gradual one — causes a significant change in the value of its reserves, which reached $2.5 trillion in March, roughly half of its GDP. “If they have a 10% revaluation against the dollar, that’s the equivalent of 5% of GDP, which is a big amount to lose. They need to think very carefully about their long-term strategy for that.”
Where does this leave the dollar? “For China, saying they’re going to let go of the peg really means they’re going to let go of trying to buy enough U.S. debt in order to maintain [the new] exchange rate,” notes Smetters. “The problem is, the U.S. is still going to try to sell a bunch of debt over the next few years, and that will create a demand for dollars. Demand for dollars is still going to be pretty strong because [the dollar] is a safe haven.”
All this raises questions about whether the RMB revaluation matters to the person on the street. Many observers in the U.S. say it does. According to them, the weak-currency policy has meant China is giving its firms an unfair competitive advantage over their counterparts in other countries by making Made-in-China products cheaper. As a result, “[China] is exporting very large doses of unemployment to the rest of the world — including the United States, but also to Europe and to many emerging market economies, including Brazil, India, Mexico and South Africa,” noted PIIE’s Bergsten in his testimony on Capitol Hill. In a blog published in January, New York Times columnist and Nobel laureate Paul Krugman wrote that “Chinese mercantilism” has cost the U.S. 1.4 million jobs.
Krugman, Bergsten and a host of other China-policy critics say that while letting the value of the RMB rise might leave consumers in the U.S. and elsewhere paying higher prices for formerly cheap Chinese goods, it will help make America’s goods more attractive both at home and abroad, which in turn will give employment levels a big boost. Bergsten reported in his testimony that “every $1 billion of exports supports about 6,000 to 8,000 [mainly high-paying manufacturing] jobs in the U.S. economy.”
But not everyone is as certain about how large a role the RMB’s value played during the global economic downturn, or is as optimistic about the effects of China’s new policy. “America needed a whipping boy to blame for the crisis,” says Simon J. Evenett, professor of international trade and economic development at the University of St. Gallen, Switzerland. He predicts that the exchange-rate debate is far from over. “It has all the ingredients of a long-running drama.” Meanwhile, he says that China Inc.’s competitive advantages could very well strengthen, rather than weaken, over time. “If an increase in the RMB value is gradual, it will just encourage a lot of Chinese companies to upgrade their products, not knock them out [of business], as some Americans hope. The principal losers would be U.S. firms.”
As for workers in the U.S., Evenett predicts that a revalued RMB won’t lead to the rosy scenario which many people say higher exports and lower imports would bring. He cites recent research on U.S. output and employment that he conducted earlier this year with Joseph Francois, professor of economics at Johannes Kepler University in Linz, Austria. For example, their research found that the majority of China’s exports to the U.S. are not destined for American consumers, but for firms in the form of components and other unfinished goods. “This is not just true for imports from China, but for all imports,” the two professors wrote in an article about their findings, published in April on Voxeu.org, a policy-analysis web site. “Consequently, imports from China and elsewhere feed into the overall cost structure of the U.S. economy and thus influence the global competitiveness of U.S. firms.”
Moreover, they observed, “in a world where only finished goods were sold — where the principal effect of revaluations is on export prices — then it might have been sensible to link revaluation, current account improvements and job creation. However, this is not the world we live in.” Evenett and Francois calculate that roughly 420,000 U.S. jobs could be lost if the RMB is revalued by 10%.
A Turning Point
In terms of what the Chinese should expect from the revaluation, Wang of CEIBS underscores the importance of looking at it alongside another big change: The rise of Chinese wages. “China is at a turning point,” he says. “For the past 25 years, wages have been growing slower than GDP. That caused a bigger problem in China” than the currency policy. The country’s current account surplus of about 15% of GDP — caused by chronic savings-consumption imbalances — has had a negative impact on the health of its economy. “Unless wages grow faster than GDP, I don’t think we can achieve an internal rebalancing,” he notes. “And it was internal imbalances that caused external imbalances.”
Marshall W. Meyer, Wharton professor of management, agrees that rising wages have a key role to play. “The wage increases are a ‘backdoor’ RMB revaluation. I’m sure prices will go up with wages, which will have to be passed on to consumers — which is pretty much what the effect of a RMB revaluation is. Unless, of course, [Chinese companies] nail down some efficiency in productivity or distribution processes, which means prices [for consumers] won’t go up as much.”
But as both Wang and Meyer note, the government has been in a corner when it comes to wages. “The government can’t avoid wage increases. It’s very conscious of its role of being ‘on the side of the people,’” says Meyer. And though still wanting to hang on to maintain the GDP’s growth trajectory, the only way the government can pursue a strategy to reduce its dependency on exports while increasing domestic consumption is to encourage higher salaries, he adds.
As Wang observes, “They really have to control the speed of change, which means they can’t let the exchange rate rise too fast. It would backfire and many people would lose their jobs. So a mild increase in wages — just a little bit faster than GDP growth — would solve the problem.”
In terms of whether a stronger RMB could lead to Chinese exporters losing business in key international markets and forcing layoffs at home, Wang believes it is unlikely, given China’s strong foothold in the U.S. and elsewhere. “You have to realize that with Chinese imports, there are no substitutes in the short term. Maybe in 10 years, importers will have a choice, but right now they will just have to pay more,” he says. “No other country can step in on a big scale. Some countries will try, [but] to build a manufacturing base and all the infrastructure that you need — transportation, energy, the entire value chain to the final good — takes many years.”
Certainly, currency revaluations alone can’t address the bigger global challenge, experts note. According to Bergsten, “Successful international adjustment … requires corrective action by the United States, particularly with respect to its budget deficit and low national saving rate, and other countries as well as by China. But it is impossible for deficit countries to reduce their imbalances unless surplus countries reduce theirs.”