RECENTLY, the United States postponed its condemnation of China as a currency manipulator, pending negotiations on whether China will appreciate its yuan. Note the United States has raised hell about somebody’s exchange rates before.
Remember “Japan Bashing” when Japan’s trade surpluses allegedly implied an undervalued yen? Trade tensions ensued, Japan occasionally acquiesced, and the yen appreciated. And appreciated – 23% in 1971-73; 37% in 1977-78; 49% in 1985-87; and 20% in 1993-95. Yet the “problem” remained. Japan still had the largest bilateral surplus in 1995 – but the bashing stopped. By then, the Japanese economy was on its knees, trapped in its lost decade.
Was the ever-appreciating yen a major contributor to Japan’s economic collapse? No consensus yet, but Stanford economist Ronald McKinnon ties the “syndrome of the ever-rising yen” to Japan’s deflation trap. Whatever the final consensus, common sense dictates skepticism attends a solution that never solves the “problem.”
Think as follows: Suppose appreciation unwinds the surplus; we get bashing, cave-in (appreciation), surplus unwound, End of Story. But, suppose the surplus remains! Then a destructive dynamic is unleashed, whereby bashing equals cave-in equals unresolved surplus setting up expectations of more and more bashing and cave-ins – as long as the surplus is not resolved! The pressure on the currency then never quite stops. Bashing is a political weapon that is itself a significant problem. Now, China’s story.
In 1994, China fixed its yuan at 8.68 per dollar to stabilise a high, volatile, inflation that had reached 20% annually. It worked. Inflation fell to track US inflation. During the 1997-98 Asian crisis, China stuck to the policy despite pressure to devalue, earning itself policy credibility. After the crisis, financial stability allowed producers to focus on real improvements – productivity, quality, cost cutting. The country utilised its abundant labour to become competitive in consumer manufactures, while the advanced economies specialised in capital intensive production – standard economic theory.
So, what’s not to like?
Hordes of rural Chinese labour flooding into world markets to rise from unrelenting poverty. Hordes of US working families buying cheap consumer goods that raise living standards.
What’s not to like?
Enter US special interests! US mercantilists and their political, academic, and media allies point to China’s surpluses with an old playbook – currency manipulation! Undervalued yuan! Enter China-bashing! In March 2005, Congress threatened a 27.5% tariff. China acquiesced and the yuan appreciated 22% over three years, but the surplus widened! Another 20%-40% needed, came the experts! Sounds familiar? How does another Asian economy deal with the thuggish return of an 800-pound economic gorilla? First, DO NOT CAVE!
Reasons why China should not cave
● Cave-ins set up a destructive dynamic: As noted, a cave-in is counter-productive and could lead to continual pressure on the currency and more economic problems.
● Argument has no merit: Why is the yuan undervalued now, not in 1994? Why didn’t the United States protest “currency manipulation” then? Because the policy was harmless until China became too competitive for US special interests! Let’s simplify matters. Suppose Google creates a phone to compete with Apple’siPhone . Business is slow but through innovation, cost cutting, Google makes a better product at lower price. Apple lobbies its politicians who threaten Google with legislation unless it raises (appreciates) its price and become uncompetitive or less competitive! The argument has no merit!
● Fixed exchange rates are not currency manipulation: The special interests demonise fixed rates as currency manipulation, but fixed rates were prevalent and beneficial in history! They insist that the very operations of fixed regimes – central bank buying/selling of foreign exchange to maintain the fixed rate – is proof of “currency manipulation” since it prevents currencies from reaching free market equilibrium! By that criterion, almost every country currency manipulates because most either fix or have managed floats. Thus, the criticism is feckless, asserting its conclusion, rather than arguing why free floats are best for developing economies, not fixed or managed floats.
● Free float is not right for China: Exchange rates today, under liberalised capital accounts, are forward-looking asset prices (like stock prices) driven by current and expected future fundamentals – news, sentiments, even bubbles. Thus, a free float will deliver trade balance (or unwind a surplus) only if foreign exchange demand mainly reflects import demand. But import demand is only a tiny fraction of foreign exchange demand, which reflects mostly asset flows (hedging, investment etc). Instead of trade balance, a free float will likely just introduce new problems of exchange volatility for China, with its yet thin financial markets.
● Sustained surpluses do not imply appreciation immediately required: No theory suggests such a rigid connection. People run life-long deficits with their grocers – no depreciations required! Historically, Britain ran large surpluses with the United States – with no attendant hysteria for appreciation or else! Why?
Trade balances are macroeconomic phenomena: a means of shifting consumption/investment profiles over time through borrowing or lending to the world. They are simply more significant than whether certain special interests are unhappy with the exchange rates they face.
● Caving would not solve the surplus but could cause deflation: As macroeconomic phenomena, trade surpluses will fall only if a country’s excess of savings over investment falls. But appreciation alone cannot ensure that. Falling exports from appreciation may cause incomes/savings to fall, but investments (and imports) could also fall. And if the surplus does not respond, as during Japan Bashing and in 2005-08 for China, a cave-in could set off the destructive dynamic of more expected cave-ins; and investments could easily move abroad. If China caves, its surplus likely remains but it falls into recession.
What Should China Do?
First, ignore the bashers and look inwards – will continuing current policy add great risks to asset/goods inflation or over-exposure to one borrower?
Second, hire a top US public relations firm to argue its case, reverse China’s role as an economic piñata in the US media.
Third, insist the US reforms its Social Security/Medicare/tax systems to incentivise savings.
Fourth, insist that bashing ends and make sure any policy revision cannot be interpreted as a cave-in or loss of control over China’s own economic destiny.
Remember “Japan Bashing” when Japan’s trade surpluses allegedly implied an undervalued yen? Trade tensions ensued, Japan occasionally acquiesced, and the yen appreciated. And appreciated – 23% in 1971-73; 37% in 1977-78; 49% in 1985-87; and 20% in 1993-95. Yet the “problem” remained. Japan still had the largest bilateral surplus in 1995 – but the bashing stopped. By then, the Japanese economy was on its knees, trapped in its lost decade.
Was the ever-appreciating yen a major contributor to Japan’s economic collapse? No consensus yet, but Stanford economist Ronald McKinnon ties the “syndrome of the ever-rising yen” to Japan’s deflation trap. Whatever the final consensus, common sense dictates skepticism attends a solution that never solves the “problem.”
Think as follows: Suppose appreciation unwinds the surplus; we get bashing, cave-in (appreciation), surplus unwound, End of Story. But, suppose the surplus remains! Then a destructive dynamic is unleashed, whereby bashing equals cave-in equals unresolved surplus setting up expectations of more and more bashing and cave-ins – as long as the surplus is not resolved! The pressure on the currency then never quite stops. Bashing is a political weapon that is itself a significant problem. Now, China’s story.
In 1994, China fixed its yuan at 8.68 per dollar to stabilise a high, volatile, inflation that had reached 20% annually. It worked. Inflation fell to track US inflation. During the 1997-98 Asian crisis, China stuck to the policy despite pressure to devalue, earning itself policy credibility. After the crisis, financial stability allowed producers to focus on real improvements – productivity, quality, cost cutting. The country utilised its abundant labour to become competitive in consumer manufactures, while the advanced economies specialised in capital intensive production – standard economic theory.
So, what’s not to like?
Hordes of rural Chinese labour flooding into world markets to rise from unrelenting poverty. Hordes of US working families buying cheap consumer goods that raise living standards.
What’s not to like?
Enter US special interests! US mercantilists and their political, academic, and media allies point to China’s surpluses with an old playbook – currency manipulation! Undervalued yuan! Enter China-bashing! In March 2005, Congress threatened a 27.5% tariff. China acquiesced and the yuan appreciated 22% over three years, but the surplus widened! Another 20%-40% needed, came the experts! Sounds familiar? How does another Asian economy deal with the thuggish return of an 800-pound economic gorilla? First, DO NOT CAVE!
Reasons why China should not cave
● Cave-ins set up a destructive dynamic: As noted, a cave-in is counter-productive and could lead to continual pressure on the currency and more economic problems.
● Argument has no merit: Why is the yuan undervalued now, not in 1994? Why didn’t the United States protest “currency manipulation” then? Because the policy was harmless until China became too competitive for US special interests! Let’s simplify matters. Suppose Google creates a phone to compete with Apple’s
● Fixed exchange rates are not currency manipulation: The special interests demonise fixed rates as currency manipulation, but fixed rates were prevalent and beneficial in history! They insist that the very operations of fixed regimes – central bank buying/selling of foreign exchange to maintain the fixed rate – is proof of “currency manipulation” since it prevents currencies from reaching free market equilibrium! By that criterion, almost every country currency manipulates because most either fix or have managed floats. Thus, the criticism is feckless, asserting its conclusion, rather than arguing why free floats are best for developing economies, not fixed or managed floats.
● Free float is not right for China: Exchange rates today, under liberalised capital accounts, are forward-looking asset prices (like stock prices) driven by current and expected future fundamentals – news, sentiments, even bubbles. Thus, a free float will deliver trade balance (or unwind a surplus) only if foreign exchange demand mainly reflects import demand. But import demand is only a tiny fraction of foreign exchange demand, which reflects mostly asset flows (hedging, investment etc). Instead of trade balance, a free float will likely just introduce new problems of exchange volatility for China, with its yet thin financial markets.
● Sustained surpluses do not imply appreciation immediately required: No theory suggests such a rigid connection. People run life-long deficits with their grocers – no depreciations required! Historically, Britain ran large surpluses with the United States – with no attendant hysteria for appreciation or else! Why?
Trade balances are macroeconomic phenomena: a means of shifting consumption/investment profiles over time through borrowing or lending to the world. They are simply more significant than whether certain special interests are unhappy with the exchange rates they face.
● Caving would not solve the surplus but could cause deflation: As macroeconomic phenomena, trade surpluses will fall only if a country’s excess of savings over investment falls. But appreciation alone cannot ensure that. Falling exports from appreciation may cause incomes/savings to fall, but investments (and imports) could also fall. And if the surplus does not respond, as during Japan Bashing and in 2005-08 for China, a cave-in could set off the destructive dynamic of more expected cave-ins; and investments could easily move abroad. If China caves, its surplus likely remains but it falls into recession.
What Should China Do?
First, ignore the bashers and look inwards – will continuing current policy add great risks to asset/goods inflation or over-exposure to one borrower?
Second, hire a top US public relations firm to argue its case, reverse China’s role as an economic piñata in the US media.
Third, insist the US reforms its Social Security/Medicare/tax systems to incentivise savings.
Fourth, insist that bashing ends and make sure any policy revision cannot be interpreted as a cave-in or loss of control over China’s own economic destiny.
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