Why China Should Not Revalue Its Currency

ANN ARBOR, Michigan: US Treasury Secretary John Snow returned empty-handed from his recent visit to Beijing to persuade the Chinese government to revalue their currency, the yuan, or renminbi. This was no surprise, since a revaluation is not in the interest of the Chinese or for that matter, of Americans.

China has pegged its currency to the US dollar (at RMB 8.3 to the dollar) since 1994. As in other countries, this was to ensure that currency volatility would not interfere with trade and investment flows on which the country's growth vitally depends, and to build confidence in the currency and the government's management of it. When a government pegs its currency, it essentially commits to a non-inflationary monetary and fiscal policy - something which the Chinese have consistently delivered.

A peg to the US dollar means that a country's currency will rise and fall in tandem with the dollar. Thus during the late 1990s Asian financial crisis, the yuan strengthened with the dollar by as much as 40% against the depreciated currencies of its neighboring Asian export competitors. At the time, China was commended by the international financial community as well as its Asian neighbors for resisting the temptation to similarly devalue, instead maintaining the competitiveness of its exports through the painful process of domestic deflation.

But this year, as the dollar has weakened relative to the euro, yen and other currencies, so has the yuan. This is simply in the nature of a currency peg. China is not "manipulating" its currency to make its exports "artificially cheap", as some American manufacturers and politicians claim. It's simply maintaining the value of its currency against the dollar as it has done for the past nine years. It's the weakness of the dollar which has caused the yuan to be weak.

The impact of this on US manufacturers and US job loss is much less than the "yuan must strengthen" lobby would have us believe. Chinese imports are too small to have much of an impact on the US macro-economy. China accounts for less than 10% of all US imports, and Chinese imports are far less than 2% of US GDP. Blaming China for the millions of jobs lost in the US during the recent recession and current "jobless recovery" is simply wrong.

US unemployment has other, largely domestic, causes from which politicians would rather deflect attention. The huge and ballooning US current account (trade in goods and services) deficit, for example, is caused mainly by record low domestic savings and a record large budget deficit. Slow growth in manufacturing has much more to do with the reluctance of US business to increase capital spending than with increased competition from imports, while productivity increases limit new job creation. Also, any increased imports from China more likely substitute for imports from other countries, like Mexico, Korea, and Europe, than represent a net increase in imports.

China's own current account surplus has been falling as rapid domestic growth in China fuels more rapid import than export growth. In particular, China runs a large and growing trade deficit with its ASEAN neighbors.

There is no question that China's exports are cheap and competitive on the world and US markets. But this has less to do with the yuan's under-valuation than with China's relative resource costs (particularly abundant low-cost skilled and unskilled labor) and increasing efficiency thanks to lower trade barriers and new technology.

Indeed, American consumers - including business consumers in the manufacturing sector - are among the beneficiaries of cheap Chinese imports. These have helped many US industries maintain their competitiveness and expand global market share in a way that would not be possible if they were restricted only to US-based production. Chinese production is now well-integrated into the global value-chains of US manufacturers.

A rise in the yuan could thus cost as many US jobs as it saves, as well as contribute to a reversal of the low inflation that US consumers have been enjoying for years, which has kept interest rates low even as the US economy recovers from recession.

Those in the US who call for a yuan revaluation assume that it will reduce imports from China and the Chinese trade surplus with the US. But this ignores the important role that those "surplus" dollar earnings of China's play in funding the huge US budget deficit and thus keeping interest rates low. China is now second only to Japan as a purchaser of US Treasury bills, at a time when other foreign investment into the US has been declining, leading to the weak dollar.

In other words, if China were to stop earning surplus US dollars (over and above what it needs for imports) and lending them to the US government, the dollar would fall even further (taking the yuan down with it), inflation would rise in the US, and so would interest rates. The cost in lost American jobs would be far greater.

If a stronger yuan is not in the US national interest, it is even less in China's. First, revaluing the yuan would make China's exports more expensive. Whereas exports are only 11% of US GDP, they are 25% of China's GDP, and a decline in exports would slow down the entire economy. More critically, a rise in unemployment would threaten social stability in China, where an estimated 30 million or more are already out of work due to mass layoffs from the ongoing reform of state-owned enterprises and the fall in import barriers following China's 2001 accession to the WTO. Both these policies - which Washington has encouraged - could be undermined if export-led growth and employment creation were to slow.

Second, a change in or lifting of the yuan peg to the dollar at this time could threaten financial instability in China, which has a heavily debt-burdened, inefficient state-owned financial system where an estimated one-third of all loans are unrecoverable. China plans to open its capital account (which would liberalize financial flows into and out of the country) in 2008 - hopefully giving itself enough time to clean up its domestic financial system before exposing it to the vagaries of global capital flows.

For China revaluation now poses an unacceptable risk. No one knows for sure how much any currency is over- or under-valued - estimates of the yuan's under-valuation range from 10% to 40%. China fears that if it simply re-pegs its currency, it will not convince financial markets that the new value is the equilibrium one. This might then simply invite more speculation as to further movements of the currency, destabilizing it and discouraging capital account liberalization.

Worse, since the equilibrium value of the US dollar is also not known, it might continue to fall (especially if the Chinese withdraw funds from the US bond market as their export earnings fall), causing the yuan to once again become "under-valued" and spurring yet more pressure for a further revaluation.

Political and financial instability in China resulting from a yuan revaluation at this time would surely undermine the main remaining engine of growth for the world economy - which is China.

Given these realities, American manufacturers and politicians need to carefully re-think their recent calls for a revaluation of the yuan. Antagonizing an ally while hurting oneself is never a wise move.