Faced with the possibility of a global currency war, Western countries are increasing their scrutiny of China’s currency policies, accusing Beijing of intervening in the markets to keep China’s currency weaker than it would be otherwise. In the U.S., politicians and regulators say such tactics undermine efforts to boost exports, and thus take away jobs from American workers. But the controversy is more complicated than that, and touches on policies and attitudes that go back decades. Knowledge at Wharton spoke with Wharton finance professor Franklin Allen and Wharton management professor Mauro Guillen about what is at stake, and why this particular conflict is so difficult to resolve.
Edited transcripts of the conversations follow.
Knowledge at Wharton: Welcome, Professor Allen. The China currency issue is one of the first things that Democrats and Republicans seem to agree on. I’m curious whether you believe that China is manipulating its currency.
Franklin Allen: I think “manipulation” is an emotive word. They’re doing what many countries have done through much of history, which is to fix their exchange rate relative to another currency. Through much of the Breton Woods period, of course, this is what just every country did. It’s what the Europeans are doing to an extreme degree in the euro. But it’s not too much different than what they did in the exchange rate mechanism before the euro was introduced. And it’s not too much different from what the entrants into the euro have to do before they actually enter properly and fix the exchange rate. So I think “manipulation” is the wrong word. They’re fixing their exchange rate, for sure.
Knowledge at Wharton: I gather that the intent is to keep the Chinese currency weaker in relation to the dollar. Is that right? And what’s the reason for doing that? How do they benefit?
Allen: This is a complicated question. Originally, I think it’s for the same reason that European countries wanted the euro. If you want to export, it’s good to have a fixed exchange rate. China thought that this was something that was beneficial for them some time ago. Over time, we have evolved and I think we’re now in a rather different position. So, originally, they didn’t run big surpluses. They didn’t have big reserves. But then what’s happened over time is that, particularly after the Asian crisis, many countries have built up big reserves. The Chinese are by no means the only ones. If you look at the smaller countries, like South Korea, they have also built up reserves.
There are many reasons for that. Part of it was the way that the IMF treated Asian countries in the 1997 Asian crisis, which led [these countries] to believe that because the government structure is dominated by the Europeans and the Americans, the Asians don’t get a fair look in. I think their response to that has been, “We need to have reserves instead.” This is one big reason for the reserves. For the Chinese, in addition, they have realized over time that reserves give them a very great deal of political power with respect to the U.S. So when President Obama goes to visit, he’s very polite. He doesn’t mention too many things about human rights and so forth, because we owe them $2.5 trillion.
The other reason, which is the one given a lot of play in the press, is that by doing this, by keeping the exchange rate low, [the Chinese] are making it easier for their exporters. I think there’s some truth to that. But I think that it’s much more complicated than is usually presented.
Knowledge at Wharton: Can you give us a couple of examples of what the complicating factors are that we don’t usually consider?
Allen: I think when the U.S or the Europeans say, “What you need to do is to let it move,” it’s not clear what the short-term rate would be, or the medium-term rate or the long-term rate, if they simply allowed it to float. It’s true that there’s a deficit on the current account at the moment that’s been there for a few years now. But there’s also the capital account. And whereas I’m sure there’s lots of money wanting to get into China, because [people] perceive the RMB to be a strong currency, I think that the reverse is also true. There’s a lot of money that wants to get out of China.
First of all, the Chinese people don’t have many instruments to invest in. And that would give them so many more, if they could take their money out. Also, of course, there’s the political reason — that if you want to hedge the risk, if you think that we may have problems in China going forward, then also they may want to take money out. In the short run, it’s not clear which of those balances would dominate. In the medium term and the long run, it’s not so clear, either, given differences in inflation rates and so on.
So, it’s more complex than it’s portrayed. My own view is that probably in the long run, the RMB will strengthen, and it probably is a good long-term investment.
Knowledge at Wharton: If the western view is often overly simplified, I’m just curious whether it’s possible the Chinese view is overly simplified as well.
Allen: Well, the problem is now, if you take the long-run view, ironically, both countries are on the wrong side. Because what the Chinese essentially are doing is giving us goods, real things, for pieces of paper. In other words, dollars. We’re getting to consume [things]. They’re getting pieces of paper whose value is very uncertain in the long run. Even if you think that there will be a revaluation of 20%, given their reserves are now about 50% or more of GDP, if you had a 20% appreciation in the RMB, they’re going to lose about 10% of GNP. This is an enormous loss for them. It’s about the same as the trade for a year. Their net contribution of trade is about 10% of GDP.
So, there’s a sense in which they’re running a big risk. But it’s also a sense in which — when we say, “Okay, you need to let it float” — what we’re doing is essentially going against our consumer interest. People always talk about jobs and the necessity of saving jobs. But these are relatively short-term interests, at least in normal times, compared to these long-run interests of them giving us goods below price and us giving them dollars in exchange.
Knowledge at Wharton: The mechanics of influencing exchange rates is more complex than just saying, “This is what we want it to be.” Can you briefly give us a glimpse into how it’s done? Purchasing U.S. Treasuries, or whatever it is?
Allen: Essentially, they go out and they purchase U.S. Treasuries. What happens is, there’s either a current account surplus or some inflow of dollars into China. So the Central Bank gets dollars, and they give people who have exported, say, RMB, an exchange. They then go out and sterilize those, which mean they increase bank reserves, or they sell government bonds, so they don’t have inflation in China.
The net result of all this is that they end up with a lot of foreign reserves. And they have offsetting debt. Now, in the long run, as I say, this is not good for them. It’s very risky. What they need to do is to change it. To get rid of this process and move towards having the RMB as a reserve currency. We need the RMB to be like the euro and the dollar, and for them to be able to behave in the same way that the U.S. and the Europeans do. They don’t need reserves if they have a reserve currency. That will make everything much easier and avoid all these problems that we’ve been talking about.
Knowledge at Wharton: This process that you’ve described, the result in the end is that it affects the balance of supply and demand of dollars. And that affects the exchange rate.
Allen: It does. Exactly.
Knowledge at Wharton: Okay. This issue is one of those things that come up; you hear about it; it’s a big thing in the news. There may be some meeting, or some U.S. official will give a speech, and we’re all in a tizzy for a while. And then it dies down. And then it comes back again. How important is it, really?
Allen: I think the exchange rate issue in itself is not that important, in the medium term. I think in the long run, it’s very important that they move to being a reserve currency. But the problem is, we’ve now got politics involved. The Americans and the Europeans demanding that the Chinese change their policies is not a good way to go. Because the Chinese won’t do it, simply for the reason that we’re asking them to do it. I think they realize that in the long run, they need to move towards having the RMB as a reserve currency. They are doing many things in that direction. For example, they are beginning to clear trade in RMB. They are allowing RMB issues in Hong Kong by foreign corporations like McDonalds. These are all moves towards having the RMB as an international currency.
The one thing that remains is to have an open capital account and a completely flexible exchange rate. [The Chinese] know that they should do that, but the more we tell them to do it, the less likely they are going to do it. A good example of how much they dislike being told what to do was provided by the border dispute that they are having in the East China Sea, in particular, with Japan. And the fact that they were so strident in cancelling the visit by the 1000 youths to Shanghai for the Expo … shows how willing they are to be aggressive in these kinds of issues. I think if we try and push them, we won’t be able to. Our position is basically the weaker one, because we’re the ones that owe them the $2.5 trillion. If they start selling and moving money into euros or into any of these other currencies, we’re quite vulnerable.
Knowledge at Wharton: Nobody likes to be bullied.
Allen: Right. The Chinese have 150 years of being bullied by the West. This is something that they feel very strongly about.
Knowledge at Wharton: In the West, I sometimes wonder whether blaming China for problems is just a convenient way of not admitting that you’re causing your own problems. Is that part of what’s going on here?
Allen: I think that is part of what’s going on here. I think we don’t save enough. We rely too much on being able to issue dollars and borrow. This is a long run problem. We need to start being more like the Germans and being more fiscally responsible. Hopefully, these problems will then go away. I don’t think we’re doing our part. We’re trying to insist that the Chinese do theirs. But I think we’ve gotten into this very bad position now.
Knowledge at Wharton: What do you think the prospects are that this could escalate into a trade war or a protectionist era that would be damaging to everybody?
Allen: I think it’s quite likely that we will get into a situation, not of trade wars — I think that the WTO is sufficiently strong so that whereas we won’t make much progress, I don’t think we’ll go backwards. But I do think it’s quite likely that governments may start intervening, as they already have done in Japan and many other Asian countries. This is not a good thing. We’re already printing too much money. The last thing we need is for these Asian countries to also be printing money to keep currencies down.
Knowledge at Wharton: If you were to look around the world and say, “This is the organization or the country or the head of state,” or whatever, “that is in a position to do something to break this log jam,” who would that be?
Allen: I think the Americans and the Europeans need to back off on this issue. I think the people who can solve it, in the long term, is the next generation of Chinese leaders. So when the new President and the new Prime Minister come in, I hope that they will look very hard at this problem, realize that having the RMB as a reserve currency is a very important thing in the long run for China, and that they will then go about dismantling these exchange controls and having it float. But we’re a long way from there, unfortunately.
Interview with Mauro Guillen:
Knowledge at Wharton: Welcome, Professor Guillen.
Mauro Guillen: Thank you for having me.
Knowledge at Wharton: Is it true that China’s currency policy is costing American jobs?
Guillen: Well, it is true. But at the same time, it is not accurate. It is true insofar as … it is harder for American companies to sell in China, if domestic consumption in China doesn’t take off. And one of the reasons why it’s not taking off is because the currency’s undervalued, right? … But the other thing that one must keep in mind is that the Chinese weakness, in terms of the currency, is also affecting the competitiveness of U.S. exports in other markets, like in Japan. I was stunned to read the other day an article, a very well-done article in an economics journal, showing that the overlap between American exports to Japan and Chinese exports to Japan is exactly 87%, which is astonishing. That means that Chinese producers and American producers are actually competing with each other in third markets, such as, for example, Japan.
So, I think it is true. Now, by the same token, it is not true. Because, you see, countries really can both benefit from global economic exchange. China and the United States don’t really compete against each other. American companies and Chinese companies compete. Companies compete. Countries can actually both win. I think the way to frame the debate right now should be how can both China and the U.S. benefit from the global economy?
Knowledge at Wharton: There’s been so much hue and cry over this, that I’m curious whether the countries that are criticizing China — to what extent they have a legitimate complaint, and to what extent it’s just convenient to point the finger at China and tell your people that it’s China that’s causing this problem?
Guillen: You’re absolutely correct. It is convenient, you know, to ask somebody else to revalue their currency. Because that automatically — you know, within 24 hours, essentially, makes your own products and services more competitive in the global economy. It is convenient, from that point of view. Now, having said that, you know, unfortunately, the Chinese currency is not really in the markets. We don’t know for sure what its value should be. But I think there is wide agreement that its value should be higher than what it is right now.
But let me also add that what is really complicating matters is that there’s a lot of uncertainty as to what the relationship will be between the dollar and the euro, because … there are large deficits here in the United States. There are problems, political problems in Europe. You know, it is still a question mark, whether European countries that are members in the euro system are going to be able to continue having a common currency or not. I can also understand the Chinese [viewpoint]. The Chinese don’t want to make a move when there is so much uncertainty as to the relationships between the other two important currencies in the world. Because they could make a mistake, if they choose to revalue — let’s say by a certain amount relative to the dollar. But that also will change the way in which China relates to the euro zone.
Given that there is so much uncertainty right now, I think it is the wrong moment from the Chinese point of view to engage in realignment.
Knowledge at Wharton: That sounds a little like the classic chicken and egg problem. What do you think it will take to break through that, and get some resolution that everybody can live with?
Guillen: Well, one option is to try to organize, once again, the coordinated action that took place back in 1985 with the Plaza Accords. At the time, if you remember the G7, China was not a player because China actually was not a very important economic power at the time. The G7, though, got together, and they decided to intervene at the markets so that … the value of the dollar would slide very, very slowly…. And it did drop in value by 30 [or] 40%, within 18 months. And that was needed, because the U.S. was, again, running big deficits and had a problem with competitiveness. And that really helped everybody overcome the many problems that were besetting the global economy back then.
Today, what I think is the best case scenario is that — not the G7, but we need the G7 plus China — perhaps also India and Russia, right? But especially China. They need to come together. And they need to come up with some coordinated action. And right now, I think the four main players — because those are the four big currencies in the world, are the US with the dollar, the Chinese with the renminbi, the Japanese with the yen, and the Europeans with the euro.
Knowledge at Wharton: What is the Chinese incentive to accommodate the rest of the world on this?
Guillen: Well, in the short run, they really don’t have an incentive because the Chinese government needs the economy to keep on growing. And the Chinese economy grows because of exports. They have a very strong disincentive to revalue their currency, because that would hurt their exports. [In the medium run, or] three to five years, or in the long run, 10 or 15 years, it is in the best interest of the Chinese to actually do this. Why? Because China is getting richer, and as China gets richer you would expect — which is what happened with other countries — that exports would decline as an engine for economic growth. And the domestic market would start being more important. Just as has happened in the United States, or has happened in Germany, way back.
Knowledge at Wharton: That’s the development of a more consumer-driven economy.
Guillen: All the consumer markets, yes. But in China’s case, there’s another complication, which is that not all the Chinese population is enjoying the fruits of economic growth. You have 300 million people who are now middle-class, and some of them are really rich, right? And then you have another 600 or 700 million in these rural areas, who are still living in poverty. The Chinese approach to the problem is complex, out of necessity, because they are facing a very complicated issue. And for them, timing is very important. That’s why I’m saying that in the short run — maybe next week, or two weeks from now — it doesn’t make that much sense for the Chinese to give in to the pressure. Let’s say three years from now, five years from now, 10 years from now, China, of course, has to develop its domestic market, and has to move in the direction that the Americans and the Europeans are now asking China to move.
Knowledge at Wharton: Now, instead of the G7, we’re often talking about the G20 these days, and their meeting in November. Do you expect any kind of breakthrough there, or progress of any kind?
Guillen: Well, I hope so. But I’m pessimistic. I think the G20 is — you know, the very name of the group indicates that it’s just too large. It’s very difficult to make 20 parties agree to anything. The G7 was already very large. Just imagine the G20. And again, as I mentioned earlier, I think the key players here are the United States, China, Japan, and the euro zone, right? And as long as those four can come to some kind of an agreement, then I think we will be in good shape. But that agreement has not become a reality yet.
Knowledge at Wharton: Now, the euro zone and the U.S. and Japan, are they of one mind on this? Or are there divisions there as well?
Guillen: No, there are divisions. And I think what happened last week with Japan’s intervention to try to slow down the appreciation of the yen demonstrates that in the absence of some kind of a four-way agreement, then each of these countries — the U.S., China, Japan, and the European Monetary Union — will try to go its own way, and defend its own interests. And of course, that can be detrimental to global economic growth. Remember that the problem with the present situation is that we’re coming out of an [economic] crisis, right? And the imbalances that led to the crisis in the first place, with big deficits in some parts of the world and big surpluses in other parts of the world, have not been addressed, right? So, we continue to have this structural problem. And politically, it’s going to be hard. Because once again … at least until now, nobody wants to give up something in exchange for an agreement, because there’s so much uncertainty as to when the global economy will start growing again in a robust way. We have the U.S. and Europe with high unemployment. The political stakes are very high. This is part of the problem.
Knowledge at Wharton: Is this situation slowing the world’s recovery from the last recession?
Guillen: Oh, I think it is. I think it is. And it is also — you know, I think it is fair to say that it is also keeping the probability of yet another problem farther down the road relatively high. We need to address these imbalances in the global economy. We need to find a way for the Chinese to feel more at ease with their new role in global economic affairs. And we certainly need to help them make the transition from being a poor developing country, and becoming one of the leading economies in the world with a vibrant domestic market based on middle class consumption.
Knowledge at Wharton: To summarize, you are not optimistic there’s going to be any immediate breakthrough. But down the road, it will be in the Chinese interest to accommodate other countries in this way.
Guillen: Yes. I just don’t think that right now, given the uncertainty in the markets, that it’s going to be easy for these four big economies in the world to come to an agreement. But I tend to think that in two or three years from now, it will be easier. But I stand ready to be surprised by our political leaders.