September 1, 2007

A Lack Of Progress On Chinese Currency

China’s real effective exchange rate (trade weighted and adjusted for inflation)—widely regarded as a more comprehensive and superior measure of China’s overall competitive position than the nominal exchange rate between the U.S. dollar and the Chinese renminbi (RMB, whose principal unit is the yuan)—has actually depreciated rather than risen slightly since the dollar peak in February 2002. The depreciation ranges from 2% to 11%, depending on the measure chosen.

So, China’s real effective exchange rate has moved in a direction opposite to what is needed. The sad truth is that the RMB is now grossly undervalued—and the appreciation of the RMB that has taken place to date against the dollar is completely inadequate to make a real dent in China’s huge global current account surplus.

When it launched its muchheralded currency reform in July 2005, Chinese authorities said they intended to increase the role of market forces in the determination of the RMB. No such thing has happened. The Chinese authorities have continued to intervene in the foreign exchange market in massive amounts by purchasing U.S. government debt—to the tune of about $20 billion a month in 2006 and $45 billion a month in the first quarter of 2007—to keep the RMB from rising.

Chinese authorities continue to assert that they do not accept the concept of currency manipulation and that the level of the RMB exchange rate is solely a matter of China’s national sovereignty. As a member of the IMF, China has obligations on its exchange rate, including avoiding currency manipulation. China’s behavior, along with the failure of the IMF to enforce its code of conduct on exchange rate policy, leads to the perception that the international community is operating without an enforced code of conduct on exchange rate policy.


If progress on correcting China’s external imbalance and on removing the large undervaluation of the RMB has been very slow or nonexistent, some might say that it doesn’t matter that much. I beg to differ.

Obviously, China’s exchange rate policies matter most to China itself. Chinese authorities have concluded for good reasons that they want to move from an investment and export-led growth strategy to a more balanced path domestic demand. They also would like to move toward a more independent monetary policy, to continue to strengthen their banking system and to be regarded as a responsible stakeholder in the international system, with a role commensurate with China’s growing weight in the world economy.

The Chinese authorities have continued to intervene in the foreign exchange market in massive amounts.

But China’s seriously undervalued and manipulated exchange rate puts at risk achievement of all these worthy objectives. It’s hard to restrain investment and reduce the volatility of aggregate demand growth when you can’t raise interest rates by much because doing so might attract large speculative capital inflows— thereby putting stronger upward pressure on the exchange rate. It’s hard to divert resources away from exports and reduce excess capacity in important tradeable goods industries when a highly undervalued RMB is sending price signals that go in the opposite direction.

And it’s hard to maintain reliable access to industrial countries’ markets for your exports and foreign investments—and indeed, to convince others that you merit a larger leadership role in helping manage the international monetary system—when you insist (contrary to your membership obligations at the IMF) that your exchange rate policy is solely a matter of your national sovereignty and that others should accept a timetable for your external adjustment that might run into decades rather than the medium term.

Although their impact is often exaggerated, China’s exchange rate policies also matter for the United States. I say “exaggerated” because the U.S. economy is operating at full employment, and China’s exchange rate policies are clearly not a key driver of aggregate employment in the U.S., although they may impact particular industry groups.

Likewise, one only has to look at China’s weight—about 15%— in the Federal Reserve’s tradeweighted index for the dollar to realize that isolated movements in the RMB would only have a limited effect on the U.S. global current account deficit; for example, a 20% appreciation of the RMB would by itself translate into only a 3% depreciation in the trade-weighted dollar. Such a small dollar depreciation might improve the U.S. global current account by perhaps $40 billion to $55 billion—a modest contribution if the aim is, say, to reduce last year’s U.S. current account deficit of $857 billion by about half.

Still, it is a mistake to downplay the helpful role that exchange rate changes in Asia can make to bringing about an improvement in the U.S. external imbalance and to reducing the risk of a dollar crash and a hard landing of the U.S. economy.

China’s exchange rate policies also carry important implications for the future operation of the international monetary system and for efforts to maintain an open international trade and investment climate. If China continues to block a meaningful real appreciation of its currency, I see two risks. First, it might induce other emerging nations to follow China’s lead in currency policy. The second risk is that China’s currency manipulation will lead eventually to a retaliatory trade policy response in the U.S.— and perhaps in Europe and Japan as well.

One impediment has been a set of arguments maintaining that faster and bolder action on reducing China’s external imbalance and its RMB undervaluation would be neither feasible nor desirable. A very popular one is that a significant real appreciation of the RMB would be disastrous for China’s growth and employment and, hence, also for its social stability.

I don’t buy it. Between 1994 and early 2001, China’s real effective exchange rate appreciated by at least 30%, yet China’s average growth rate during that period was 9%, and in no single year did growth drop below 7.5%. It is estimated that a 10% real effective appreciation of the RMB would lower China’s growth rate by only 1% to 1.5%, as compared to its current 11% rate.

A second erroneous contention is that an appreciation of the RMB much beyond the rate of recent years would cause major disruptions to China’s financial sector—particularly its banks— and that bolder exchange rate action has to wait until China’s financial system is much stronger than today.

I would say that a …10% percent appreciation in the real effective exchange rate of the RMB will induce a deterioration in China’s trade balance of between 2% and 3.5% of GDP.

The correct diagnosis is that full capital account liberalization in China has to wait for a strengthening of China’s banking and financial system—not that exchange rate appreciation has to wait for financial sector reform.

A third myth is that RMB revaluation would be ineffective in correcting China’s external imbalance. If there is an emerging consensus, I would say that a ballpark estimate is that a 10% percent appreciation in the real effective exchange rate of the RMB will induce a deterioration in China’s trade balance of between 2% and 3.5% of GDP. If the demand for China’s exports was really as inelastic as some of the critics of RMB revaluation contend, it’s hard to see why the Chinese authorities would be so resistant to an immediate and sizeable revaluation. In that case, the higher foreign currency price of Chinese exports would produce an increase—not a decrease—in total export revenue.

Myth No. 4 is that the IMF should not act as a global umpire for exchange rate policy— notwithstanding the mandate in its charter—because doing so would conflict with the IMF’s role as trusted advisor to its member countries. But why should the two roles conflict unless the Fund were giving countries advice on exchange rate policy that violated its own currency manipulation guidelines? And even if the two roles did conflict, why is not the umpire role the more important one?

Yet a fifth weak argument is that having U.S. Treasury name China (or others) as a currency manipulator would only be counterproductive in motivating the desired exchange rate outcome and would brand the U.S. as protectionist to boot.

When the Treasury finds that China has not been engaging in manipulation, it reduces the dispute to a bilateral difference of opinion about how fast China should move on increasing the flexibility of the RMB—with China preferring a slow, gradual approach and the U.S. favoring a more rapid one.

In contrast, if China were found to be engaging in currency manipulation—not just by the U.S. Treasury but also by the IMF—it would send a strong signal that the international community regards China’s exchange rate policy not only as ill-advised, but also illegal and counter to China’s membership obligations in the IMF.

A 10% to 15% appreciation of the RMB could be accomplished either by a step revaluation of the RMB or by cutting way back on China’s exchange market intervention so that the RMB floated upwards. The undervaluation of the RMB has now become so large that a phased approach to exchange rate adjustment has become necessary.

That said, it should be clear by now that a very modest rate of upward crawl of the RMB relative to the U.S. dollar is not going to solve the problem.

For its part, the U.S. needs to clarify and strengthen its message on what it wants China to do on exchange rate policy, while simultaneously demonstrating its willingness to make a larger contribution of its own toward reducing global payment imbalances.

The U.S. Treasury should indicate to the Chinese that henceforth it will consider movements in China’s global current account surplus, in China’s real effective exchange rate and in the monthly amount of China’s intervention in the exchange market as the key benchmark indicators in assessing China’s progress on external adjustment and currency reform.

The U.S. authorities should also seek to marshal support from both other industrial countries and large emerging economies for establishing the IMF as the global umpire for exchange rate surveillance.

As suggested earlier, the Chinese exchange rate problem is part of the wider issue of achieving a better and more equitable pattern of burden-sharing in correcting global payment imbalances. To ensure the U.S. approach to this problem is even-handed, U.S. authorities should assure the Chinese (and others) that the same benchmarks and methodology used to evaluate progress on external adjustment and exchange rate policy in China will be applied to other economies.

Equally important, the U.S. should indicate it is prepared to offer a new longer-term plan for greater and more durable fiscal consolidation in the U.S. This in turn should give more confidence to other countries and private markets that the U.S. is adequately addressing its low national saving rate while making room for an expansion in U.S. net exports that would accompany a depreciation in the real effective exchange rate of the dollar.

Last but not least, the IMF should return to its roots by taking up in earnest the role that its founders set out for it as the global umpire for exchange rate policies. The WTO is already serving in a parallel role as global umpire for trade policies. Through the rulings of its adjudication panels, it is becoming clearer over time what is and what is not internationally acceptable trade policy.

A similar exercise has to begin for exchange rate policy at the IMF. The best protection against protectionist trade policies is the assurance that a competent, unbiased international umpire is considering seriously potential abuses of exchange rate policy and issuing fair, well-reasoned findings.

Morris Goldstein is the Dennis Weatherstone Senior Fellow at Peterson Institute for International Economics in Washington, D.C. The column is excerpted from a paper that updates and expands his testimony, “Assessing Progress on China’s Exchange Rate Policies,” before the Senate Finance Committee earlier this year. The full report can be seen at www.iie.com/publications/wp/wp07-5.pdf.