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To Revalue or Not to Revalue, That is the Question Facing China’s Leaders
by Satya J. Gabriel

Hysterical pronouncements about China have been issuing from Western media headlines: “China in World Spotlight Over Currency Controversy.” “Fed Is in a Dangerous Game with China.” “Millions of U.S. Job Losses Blamed on China’s Refusal to Revalue Its Currency.”

Recently four prominent senators called on U.S. Treasury Secretary John Snow to investigate China’s manipulation of its currency markets to keep the yuan (also known as renminbi—“people’s currency” or RMB) pegged at ¥8.28 to the dollar.

American officials and a wide range of American economists argue that the yuan is significantly undervalued. This market-distorting intervention subsidizes Chinese trade, makes Chinese exports artificially cheap, and causes huge job losses in the U.S., they maintain. The result is an alarming trade deficit with the PRC ($110 billion in 2002 and rising this year), and the concomitant huge buildup by China’s central bank of foreign-currency reserves ($350 billion) and U.S. government bonds ($122 billion). China’s trade imbalance with the U.S. has resulted in Beijing becoming one of Washington’s biggest creditors, and this provides the PRC government significant leverage over its American counterparts.

This is why the trade imbalance is a problem. Indeed, Japan and Germany have had a similar relationship with the United States, using a trade imbalance as the basis for accumulating U.S. government bonds and then using their bond holdings as a lever to “encourage” the U.S. government to take policy stands that were more to their liking. Japan’s central bank still holds more U.S. government bonds than any other non-U.S. institution, and the total value of Japanese institutional holdings of U.S. government bonds is more than three and a half times that of China, indicating a much longer-term drain of dollars from the U.S. to Japan than anything yet experienced between the U.S. and China. If for some reason the Japanese central bank decides it does not want U.S. government bonds anymore and dumps its holdings onto the market, the impact on bond prices (and interest rates) would be quick and devastating to the U.S. economy. There is no reason to assume that Japanese officials would do such a thing. After all, Japan is still an ally of the United States. China, on the other hand, is not. Indeed, China is perceived in Washington as the only real potential rival to U.S. global hegemony.

This being the case, it is not difficult to understand why it is of concern to American policy makers that China is becoming such a huge creditor nation. But there are other reasons for U.S. government officials—especially Federal Reserve Chairman Alan Greenspan and Treasury Secretary Snow—to complain about Chinese government economic policies. The U.S. economy continues to grow at a sluggish pace, at best, and jobs continue to disappear. Indeed, it is only because a recession is defined by output declines, rather than employment declines, that the U.S. economy is officially in recovery. It certainly does not feel like much of a recovery to most “blue collar” workers.

It was not that long ago that the primary target of official scapegoating was Japan. It was the Japanese that were taking good American jobs. Even more recently it was the Mexicans. But now there is a much better target: China. The Chinese are not playing fair. They are taking good American jobs by keeping their currency too cheap. Never mind that current economic ills can be traced to decisions made by U.S. state officials, in particular the Federal Reserve Open Market Committee, when they decided in the waning weeks of the Clinton presidency to trigger a recession by raising interest rates. It took a lot to slow down the Clinton economic boom, too much perhaps. The Fed raised rates far too aggressively and when the economic slowdown finally came it proved far more resistant to reversal than was anticipated by Fed officials who had come to believe all the rhetoric about what brilliant economic planners they were. After repeatedly lowering interest rates and jawboning, the Fed has done little more than stimulate a housing boom (and perhaps a mild speculative bubble in housing prices).

The fact that U.S. politicians want to find a scapegoat does not, however, mean that Chinese government policies have no role to play in the current economic environment in the U.S. But is it the negative role that these policy makers claim it to be? The argument is that a cheap yuan results in lower unit costs for Chinese manufacturers (including American and European transnationals manufacturing in China), which allows for low-priced exports to the U.S. These cheap exports displace higher-priced American goods, inventories build up at U.S. factories, and the result is layoffs or, even worse, plant closings. Thus, it is argued that Chinese officials are responsible for the job losses in the U.S. There are two obvious flaws with this argument. One of the problems was made clear by Greenspan himself, although perhaps he was not aware of the contradiction. He pointed out the increasing importance of the information economy to future economic growth. To the extent the U.S. economy has already shifted from manufacturing to information technology, cheap imports of clothing, toys, and other labor-intensive, low-tech goods from China do not pose a serious threat to future U.S. growth. If the problem is insufficient demand for existing information technology, then this problem was exacerbated by the Fed’s successful attempts to slow the U.S. economy and the related bursting of the speculative bubbles in information technology and telecommunications. Second, and perhaps even more importantly, the Chinese government policy of buying heavily in the U.S. debt market has contributed to much lower interest rates than would otherwise prevail. These low interest rates have been instrumental in keeping the U.S. economy from falling further and faster, including stimulating the aforementioned boom in housing.

In other words, public policies formulated in Beijing have actually been beneficial to the U.S. economy. Furthermore, cheap Chinese-made exports into the U.S. economy, the source of ire for U.S. government officials and politicians, have benefited American consumers. The effect of lower-priced consumer goods is to increase the real income of these consumers. They can buy more, and live better, than without these low-cost imported goods. The money saved on goods made in China may, in fact, result in increased purchases of the more capital- and knowledge-intensive goods manufactured in the United States, and may stimulate more spending on services and other goods that generate jobs in the domestic economy. It is, therefore, not quite so clear that an undervalued yuan (if, indeed, it is undervalued) is a zero sum game.

Is the yuan undervalued? This is also not as straightforward as it might seem. Yes, China is running a trade surplus with the United States because of the demand for low-priced, Chinese-made goods. However, the low cost of Chinese goods is not simply a result of the value of RMB. Low unit costs are the result of relatively low dollar-cost labor in China. It is quite likely that wages in China are higher, not lower, in dollar terms than would be the case with significantly less government intervention. On the one hand, if the Chinese government dramatically expanded the trading band for RMB, such that a lot fewer yuan could be used to buy a U.S. dollar, then this would place upward pressure on the average dollar wage in China. However, the Chinese government could also stop artificially propping up yuan wages by using bureaucratic mechanisms, including keeping many more people employed than are needed in state-owned enterprises and within the government bureaucracy, with the result being a sharp fall in yuan wages. The rise in the dollar value of the yuan might be more than compensated for by a fall in the yuan wage, resulting in a lower dollar wage for Chinese workers and even lower unit costs than currently prevail. It would still be cheaper for Americans to buy Chinese goods.

However, it is likely that any shift in government policy that allowed a much higher rate of unemployment and lower wages would seriously damage the domestic Chinese economy, create political instability, and halt the growth machine. A sharp slowdown in the Chinese economy, coupled with increased political instability, would likely cause the yuan to depreciate within the new trading range. It is interesting that those who argue for a free-floating yuan (let the market determine the exchange rate) usually argue for less Chinese government involvement in other aspects of their economy, including the labor market. The worst-case scenario would be to float the RMB while simultaneously eliminating the institutional impediments to more sharply rising unemployment. A repeat of the 1997-1998 Asian economic crisis would be, under that scenario, an optimistic outcome.

At the end of the day, Chinese authorities will likely drag their feet on the question of revaluation, not to mention on the issue of a free-floating exchange rate. They recognize that their actions during the Asian economic crisis—keeping the peg—gained them a great deal of credibility and have been beneficial to China’s economic growth and development. This is not something that the leaders in Beijing are likely to give up easily or anytime soon.

The irony of this debate about revaluing the RMB is that it has probably added impetus to American and European investors and transnationals to increase their involvement in the Chinese economy. Both portfolio investors and firms engaged in direct investment in the Chinese economy would have a positive incentive to shift more resources into China while the yuan is relatively cheap, if they expect a higher dollar cost to such investments in the future. Thus, it may actually benefit the Chinese economy to have such expectations raised.

Satya J. Gabriel is currently associate professor of economics at Mount Holyoke College and a member of the steering committee of Asian Studies. He is also academic coordinator of the Rural Development Leadership Network. During 1996-1998 he served as a professor of economics in the Nanjing-Hopkins Center at Nanjing University.

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