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How to Deal with the Chinese Exchange Rate

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By Dr. David A. Phillips


I’d like to deal with a few important aspects of the long term problem of economic relations between the United States and China, something that has deserved – and received – extensive study and commentary.

The 2010 International Monetary Fund Article IV Report, based on its annual consultations with country governments, concluded that the Chinese currency was substantially below the level that was consistent with “medium-term economic fundamentals.” This meant that it underpriced Chinese exports and overpriced Chinese imports, assisting in a large and rapidly increasing Chinese trade surplus, to the detriment of competing economies. The Chinese authorities disagreed on the interpretation of the evidence and some members of the IMF Executive Board concurred with China. But at the extreme, some U.S. observers thought that the global financial crisis itself could be blamed on the imbalances caused by Chinese monetary and exchange rate policy.

The debate on Chinese exchange rate misalignment has continued since the 1990s. While the United States is concerned about its debt obligations to the Chinese government and its growing competitive disadvantage, at the receiving end of low-priced Chinese imported products, with even more consequences than those facing the U.S., are probably the many developing countries that face Chinese competition. Manufacturing industries of Africa such as textiles and garment production have been unable to survive the relentless competition. There has been a process of de-industrialization in Africa for the last 20 years. While in the short term, poorer economies might be able to defend themselves through a competitive depreciation or real devaluation of their currencies against the dollar, this process merely exacerbates the U.S. current account deficit and the longer term pressure on the dollar.

In the United States, the debate about the Chinese Yuan gathered steam as a result for example of comments by Paul Krugman in 2009 in which he argued that exchange rate misalignment by China was damaging the U.S. and that facing off with the Chinese government was a low risk and justified strategy. He wrote that the pegging of the Yuan to the dollar gave Chinese manufacturing a large cost advantage over its competitors while the undervalued rate was supported by the government’s controls on capital imports and at the same time the government’s action of buying up dollars and investing them outside the country, in for example U.S. Treasuries. This in turn had kept down U.S. interest rates and supported the explosion of risky bank lending. (At the end of 2009, China was the top foreign investor U.S. government debt, with holdings of $900 billion in Treasury securities).

Following the crisis, with interest close to zero as a result of the worldwide recession, the Chinese capital exports simply led to a buildup in liquidity, draining demand from a depressed world economy. Krugman suggested that Chinese “mercantilism” could reduce U.S. employment by around 1.4 million jobs by 2012. He later repeated his argument, stating that China’s currency policy was depressing economic growth in the U.S., Europe and Japan. “If we could get some change in China’s currency policy, it would help the world.”

Despite the certainties of some U.S. and other commentators, and even the unusually single minded statement of the IMF, there remains much disagreement about what determines the correct equilibrium exchange rate on which to base the measure of exchange rate misalignment, if any. The estimate of misalignment is very sensitive to variations to small changes in calculation assumptions such as time periods for estimation. Using various different approaches the estimates of currency misalignment have in fact ranged from significant undervaluation (33 percent or 49 percent) to significant overvaluation (33 percent to as much as 100 percent) and many points in between these extremes. When the World Bank revised downward the estimate of Chinese GDP to take into account Purchasing Power Parity, the estimated undervaluation disappeared.

Even if it was possible to establish whether there was a misalignment, this wouldn’t be the end of the story, for several reasons. First, the “appropriate” exchange rate for targeting would need to be identified and it is not necessarily clear how to do this. Second, the international community would have to judge what should be done about it and which countries, if any, should be compensated. To complicate matters, over the past few years the Chinese have allowed their currency to appreciate slowly against the dollar in both nominal and real terms even as China’s current account surplus has still continued to widen.

While some economic observers rail against Chinese mercantilism and short sightedness, it seems highly probable, given the number of Chinese macroeconomists trained in the United States, that the entire problem is perfectly well understood within the Chinese government; it is also aware that the fate of the United States and Chinese economies are intertwined in trade and monetary co-dependence, and that it’s searching for ways to remedy it. At the same time, it has to be remembered that the Chinese government is responsible for the fate of a nation that comprises about one sixth of humanity, of which a substantial part (approximately 200 million) still live in severe poverty despite the economic progress achieved in the past 20 years. A serious macroeconomic policy mistake by the Chinese authorities could potentially have a far more damaging effect (say in terms of increased unemployment) on the Chinese people than a similar mistake in the United States, whose population consists of about one twentieth of humanity, of whom about 90 percent live at a far more comfortable level than the vast majority of Chinese. Just on this basis it appears to be a very good idea to continue to resolve the global imbalance problem facing China, the United States, and other countries by working together to adopt comprehensive reforms of the exchange rate regime and also domestic structural reforms in their respective countries, including in China the rebalancing of domestic demand toward private consumption through boosting household incomes, and in the U.S. the shift of consumption to savings involving some lowering of relative real wages.

Given the confusion about what constitutes an appropriate exchange rate system, exclusive and aggressive focus on the exchange rate issue is likely to be both ineffective and counter-productive, especially if aggressive tactics are deployed to this single problem. There’s little alternative for the U.S. to diplomacy and persuasion, possibly backed up as a last resort by piecemeal measures such as selective import tariffs t

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