Chinese renminbi: lost in translation

The foreign exchange markets have been rife with speculation over China's revaluation for some time. In the run-up to the G7 meeting, American political pressure is intensifying. The rationale for realignment is that it would help to achieve a reduction in the American current account deficit, which has hit an unsustainable level of about 6% of GDP.

A case has been made on how a huge current account deficit with China is preventing the current account adjustment, and that this gives China an unfair trade advantage. This necessitates taking a closer look at the case for an immediate, large renminbi revaluation and why this may not be the best case scenario for China.

The case for revaluation is based on the following arguments:

¤ In the absence of a flexible exchange rate, China is overheating;

¤ China requires a higher real exchange rate to achieve a structural economic catch-up;

¤ A status quo results in an unfair cost advantage for China; and

¤ Its absence causes inefficient allocation of resources.

Even if one were to agree that without a significant rise in the renminbi the Chinese economy would continue to overheat, there is no unanimity over what the 'fair value' is for the nominal exchange rate.

However, there is a danger that if the capital account were to be fully liberalised, this may result in Chinese savings heading abroad and causing instability in the exchange rate. The Chinese would be reluctant to play roulette with the exchange rate, which has been a source of stability for the past decade.

The second argument is that China would enjoy a rise in real exchange rates that comes with its gradual economic catch-up with the more industrialised economies. However, the real exchange rate can rise by just ensuring that the inflation rate remains higher than the trading partner, and may not have to move on exchange rates.

The third argument that the exchange rate is deliberately undervalued does not make sense. Even a major revaluation of 25% against the dollar would scarcely make any difference to the American economy. China accounts for 10% of total US trade. Therefore, a 25% revaluation would lead to a 2.5% devaluation of the US dollar, which would be a drop in the ocean relative to the current US dollar rout.

To bring the American current account deficit to 2-3% of GDP from the current 6% would need a massive 33% devaluation in the relative value of the US dollar. Hence, China and Asian currency adjustments would not make any difference.

China's trade surplus with America has been offset by a growing trade deficit with the rest of Asia. Asian countries are increasingly sending their goods to the US via China. China has a huge cost advantage in manufacturing, which would not be dented by any such adjustments. Chinese manufacturing wages averaged less than US$800 per annum in the second half of the 1990s, whereas those in the US averaged around $29,000 per annum during the same period.

The fourth argument makes some sense, but if capital controls were removed it would create huge exchange rate uncertainties. Such changes could result in a financial market crisis like the ones that hit Mexico in 1994 and Thailand in 1997.

It is now opportune to look at the conventional wisdom on the Chinese revaluation story and determine if this makes sense. There are a few myths.

One of the myths is that China has gained manufacturing jobs at the expense of other countries. This is not factually true. China may not have lost as many jobs in the manufacturing sector as some other countries but there has been no net job gain. China's domestic restructuring has given rise to massive gains in the private sector, which has offset huge job losses in the state-owned enterprises.

It is believed that China's bilateral trade position vis-à-vis America proves that its exchange rate is undervalued. As already mentioned, this is not true as the overall trade position is of a very moderate surplus. Its gains against America have been offset by losses against other Asian countries and commodity producers. Overall, China's trade surplus has fallen, not risen, in recent years.

So, if a revaluation is not a viable solution and the US dollar's status as the world's reserve currency starts slipping, what alternate strategy can China adopt? China could consider a free float that is associated with inflation or money supply target.

Another solution could be that it widen the bands and live with some uncertainty. This may not be a good alternative, as it would aid a build-up of speculative forces. China could also adopt a currency basket, reflecting China's main trading partners. American trade accounts for only 17.7% of China's trade.

China could also look into a move to peg against the euro, if commodities are increasingly priced in euro rather than the US dollar. This would create a problem for Asian countries, which are pegged against the US dollar. If nothing changes, this move would increase uncertainty over pricing.

Another solution could be the formation of an Asian currency union on the lines of the Eurozone. It is unlikely that Asian currencies would be replaced by a new single currency but it might be easier to link all the currencies permanently to another currency.

A revaluation of the Chinese currency would have very little impact on global economic imbalances. Western policymakers are just using China as an excuse. Any pro-active change in China's foreign exchange regime should be seen in the light of US dollar developments.

The strongest case of change in regime would come from concerns that the US dollar no longer offers the best qualities as the reserve currency.