May 1, 2005

Hey, Buddy, Yuan a Fight?

Dr. Peter Morici has iconoclastic views on Asian currency. It's about time someone spoke up for North American manufacturing.

The United States is running the biggest trade deficit in its history—or anyone else's history, come to that. It is buying more goods from the world than it is selling back, to the tune of more than $600 billion a year. And quarter by quarter, the deficit widens. So why is that?

Peter Morici, a professor of business at the University of Maryland and the former director of economics in the U.S. International Trade Commission, thinks he knows the answer. In one word: China. For Professor Morici, China is not just the world's fastest developing industrial power, the coming economic hyper power and the emblem of the transformation of Asia. China, says Morici, is also suppressing U.S. economic growth, limiting U.S. employment and driving not only the trade deficit, but the U.S. budget deficit, too.

“The relationship with China is becoming ever more detrimental to the United States,” Morici says. “China is practicing a form of economic imperialism.”

But this is an unconventional imperialism, argues Morici, because China's weapon of choice is its currency, the yuan. For a decade, the Chinese currency has been pegged at a steady rate of exchange to the U.S. dollar, so that one dollar always buys 8.28 yuan. But that, argues Morici in a recent paper entitled “Currency Manipulation and Free Trade,” is way below the exchange rate that the market would set. He believes that the yuan should be worth much more, and that its current strength is placing U.S. exporters at an intolerable disadvantage. The cheap yuan fuels the U.S. trade deficit, as a cheap yuan means cheap Chinese textiles and plastics, mobile phones and computers.

China maintains the value of the yuan against the dollar as a matter of policy. The Chinese government suppresses the value of its own currency by purchasing U.S. dollars in the domestic Chinese market, and then it recycles those official holdings back into U.S. government securities—one reason the U.S. government is able to run such a large and growing budget deficit. Indeed, while many economists think that U.S. government spending is helping to swell the trade deficit, Morici argues that things actually work the other way around. “You have to understand this can work both ways,” he says. “Budget deficits can drive trade deficits. But trade deficits can also drive budget deficits—and that is what's happening, thanks to cheap Asian currencies.”

It is not just China, either. Morici says that other Asian currencies are also too cheap. South Korea and Taiwan also need to hold down their currencies to maintain their competitiveness with China. So even though the yen has gained about 4% against the dollar since last fall, the won has risen by almost 12% over the same period, and the Singapore and Taiwanese dollars are at their highest for six and three years respectively, China is the key to the problem, he says. “It's like your grandmother told you—you've got to knock down the biggest bully in the playground, then everyone else will leave you alone.”

The Morici argument is contentious, and it goes to the heart of a disagreement about how to understand what everyone agrees is a massive financial imbalance in the world. The economic consensus is that the trade deficit is the byproduct of very low household saving in the United States, tax cuts, excessive stimulation by the Federal Reserve and massive government over borrowing. But are Asian competitors using artificially cheap currencies to build their economies at the expense of U.S. jobs? Or is it the other way around, as commentators like Ronald McKinnon at Stanford University have argued—that the United States is using the status of the dollar as the world's reserve currency to finance its own spending boom?


The arguments start with the central proposition—the idea that the yuan is undervalued. But is it? China's current exchange rate has not stopped it importing almost as much as it exports. Although Chinese trade accounts for about a quarter of the U.S. trade deficit, on a global basis China has a relatively small surplus ($32 billion last year). The Chinese can point to the fact that according to their figures, their foreign trade is almost in balance as a marker of the fair value of the yuan, at least on a global basis. However, competent authorities suspect that Chinese-sourced historical data is not entirely reliable, although it is improving fast thanks in part to World Trade Organization compliance efforts.

Nevertheless, a country with an economy growing as rapidly as China should, in principle, experience a rising currency. There is little doubt that if China maintained its capital controls but moderated its official buying of dollars, moving to a wider currency trading range, or pegging the yuan to a mixed basket of trading partner currencies, then the Chinese currency would begin to appreciate against the dollar. By how much is a guess. Morici says the yuan should be at about five to the dollar, a revaluation of nearly 40%. Others, like Morris Goldstein at the Institute for International Economics in Washington, D.C., reckon that a market rate for the yuan would revalue the currency less than that, by around 15%. Eswar Prasad of the IMF recently published a paper arguing that it is impossible to know if the yuan is undervalued or overvalued—there is no convincing evidence either way, he believes.


Whether any revaluation in the 15% range would have the desired effect of greatly shrinking the U.S. deficit and improving U.S. employment growth is hotly debated. Morici concludes that a rising, unpegged yuan would cut the U.S. deficit in half. Others disagree. Economist Laurence Lau of Stanford, for example, has argued that the relatively low share of Chinese value-added in Chinese exports to the U.S. means that a revalued yuan will not make much of a difference to Chinese export prices—although it might well disproportionately advantage U.S. exporters to China, who are less reliant on input prices in currencies other than their own.

And there is another side to the currency argument. China is growing fast thanks to foreign direct investment, much of it from the United States. Indeed, says Stephen Roach, chief economist at Morgan Stanley, the idea that a yuan revaluation will profit U.S. industry overall is plain wrong. Roach says two-thirds of China's export growth in the last decade is attributable to foreign direct investment, and a fall in the profitability of this investment through currency appreciation could also mean a fall in returns from many U.S. companies with cross-border operations. In other words, for every lobby against the low yuan, there is likely to be another lobby in favor.


The complexities of this globalized economy, where a loss of Chinese currency competitiveness may turn into a loss of profitability for U.S. companies, points up a fundamental issue in the dispute. Is the economy of China growing at the expense of U.S. jobs and GDP? Or is the relationship more symbiotic? Robert H. McGuckin, the head of economic research at The Conference Board, believes in mutual advantage. “The fact is that the global productivity wave is making everybody richer,” he says.

Morici is having none of that. He believes that a revaluation of the yuan would translate directly into a GDP boost for the United States of $500 billion and as many as 5 million additional U.S. jobs. But he also thinks that it would take some very tough talking to achieve a market rate for the yuan.


“We have run out of positive incentives for China,” Morici says. “Now we have to insist on a currency agreement. We should sit China down and say that if the yuan is not floated within a period of say three years, then we can't go forward on the current basis. We can't continue trading on a Most Favored Nation basis.”

In other words, he favors breaking up the political consensus that has allowed China to develop and reform at its own chosen pace. Will that consensus be broken? In fact, the professor doubts it. “No,” he says, “I don't think the United States is actually going to do a great deal. I don't think this administration gets it. It doesn't recognize that free trade in goods requires free trade in currencies.”