The U.S. Congress is running scared. With a mid-term election coming up and a populace that is unhappy about the economy, they have resorted to be mad about something, and that something appears to be China – specifically China’s valuation of the Yuan (RMB). The argument goes:
China is keeping the yuan artificially low. In keeping the Yuan low, China is stealing job from America, preventing America from undergoing a quick economic recovery. China is artificially manipulating its currency to gain an unfair trade advantage against America. America must wake up and do something. China doesn’t listen to reason. If the U.S. must go into a trade war with China, so be it.
Let’s take a look at the engine under the hood of such reasoning.
First, what does it mean for a country to keep its currency artificially low? Some believe the only fair value of currencies like the RMB is the value the “market” assigns the RMB – possible only if RMB is allowed to freely float. The problem, as I discussed in a previous article on Yuan valuation, is that there is no such thing as a free market for currencies. The buyers and sellers of currencies are big financial institutions and central banks which dominate the global transactions of currencies. To argue of a fair market value of currency as a “norm” is to believe we should entrust financial institutions in Wall Street financial and Central Banks like the U.S. Federal Reserve (the same ones that created the unchecked property valuation of the U.S. housing bubble) to set the terms of global trade. While the notion of a free-floating currency has a semblance of “free market fairness” to it, it is but another name for governments and financial institutions of the developed world to control global trade on the big boys’ terms.
Others believe that a purchase-power based valuation of currency is the sole fair way to value currencies like the RMB. But as I also discussed in my previous article on Yuan valuation, the notion that the valuation of nontradable goods and services in different countries – especially between developing countries and developed countries – can be practically converted is a hollow concept. Just because the price of a haircut in China may be 1/10 of that in the U.S. does not mean the price of the Yuan is 90% undervalued. Even moving to tradable goods and services, just because the price of an imported car can be 2-3 times that of the U.S. does not mean the Yuan is 50% or more undervalued (part of the different is due to government tax to build roads and to dissuade people from buying gas-guzzling cars).
Comparing a basket of prices does not help. As McKinsey has noted, until China accomplishes many other basic reforms in its economy (land reform, reform of the energy sector, state-owned-enterprise reform, social welfare, among others), the price of many goods and services in China will be inherently unconvertible. When some 50% of cyclical movements of currency exchange rates between developed economies can be affected by ratio of price of non-tradable to tradable goods and services, prescribing an exchange rate between the RMB and the U.S. Dollar based on “purchase power” when most of China’s nontradable goods and services are not even theoretically convertible is silly.
To make things more difficult, China is a developing country that include unevenly developed micro economies. The price of goods and services in a place like Shanghai is very different from that in a place like Chongqing which is very different from that in a place like Lhasa. The same difference can be seen between different cities in the U.S. such as that between L.A. and Kansas City, except magnified one or two magnitudes larger. Even if the Yuan were “fairly priced” with respect to Shanghai, it may not be with respect to the rest of China.
If there is no inherent fair value of the RMB, does the fact that China has racked up trade imbalance with the U.S. prove that China’s currency is undervalued? As I discussed in a previous article on the U.S. trade deficit with China, the fundamental cause of the trade imbalance between the U.S. and China is due to a differential between U.S. savings rate and Chinese savings rate (please see linked article, which includes also hard data proving that assertion). As long as the U.S. saves less than the Chinese, the Chinese will be a net holder of U.S. dollar. If the Chinese were to magically slash the value of the RMB in half, China would not automatically double its holding of the dollar in real terms. The difference can be made up only by increased difference in savings rates between the U.S. and Chinese economies. With no structural change in net savings, China would simply simply have to work twice as hard – selling twice as much goods and services to the U.S. as before, with the U.S. consumers pocketing all the benefits of that discount.
The best way to think about the dispute the U.S. has with China’s yuan is to go back to the fundamentals. The conversion rate between nations must be set so that overall there is a sustainable balance of payments. Nations in general want to set the price of their currency as high as possible – so they get away with buying more with selling less. Unless for specific and short term tactical reasons, no nation ever wants to reduce its currency vis a vis others.
The idea that China is a special case where the nation as a whole is not interested in profits and hence can afford to set its currency arbitrarily low for long terms is absurd. Go talk to any Chinese business and ask if profit is important for them. Go to China and witness if its broad-breath economy can grow without profit, if millions and millions of people can be lifted out of poverty without profit. Of course China has an inherent interest in making a profit and keeping the value of the RMB high. How much profits the Chinese demands is their own sovereign business. The fact that they may not make as much as the U.S. as a country would itself want is no argument that the Chinese are trading unfair.
The fact is that as long as there are differences between economies, one can always find “unfairness” in trade. Consider what I wrote in my previous article on Yuan valuation:
[T]he fact of the matter is that China and U.S. are at very different stages of economic developments. Even if the whole of the Chinese economy operates using the dollar only, many things will still appear inherently unfair.
People in China (and across the developing world for that matter) work more for less pay. Average wage in China is some 1/10 of that in the U.S. The labor standards, environmental standards, and social safety networks in China are all weaker than that in the U.S. Even between developed nations, differences in labor standards and fiscal policies (involving subsidies, currencies, etc.) between European nations, Japan and the U.S. still lead to regular trade disputes.
Does this mean the U.S. should disengage from international world – or at least reduce trade with developing nations like China until they come to the same standard as the U.S.?
I don’t think U.S. should disengage from globalization in the name of unfair wages or devalued currencies.There are costs and benefits to being a low wage country with an inexpensive currency. It is China’s prerogative to decide what role it wants to play in the global economy. I’d be flabbergasted if China is really pursuing a policy of purposely devaluing its currency. Why would any nation voluntarily want to devalue itself over an extended amount of time to be a slave to others? The path to riches is to move up the wage ladder, not down. I’ve never heard of a story of a pauper bootstrapping its way to riches by depressing its wages.
To the extent the Chinese government is really deliberately pursuing a policy to “deflate” its currency (whatever that really means), let them do so. They would only be setting a tax on their citizens for the benefit of the global economy. To the extent China is willing to depress its currency and its profits, the rest of the world should gladly accept China’s discount.
What the U.S. needs to focus on in terms of its own economic development is its culture of living beyond its means. America’s real estate market is still overinflated; the government debts are going out of control.
The U.S. and China occupy different levels on the global value chain. What’s the point of making the Yuan higher? Does the U.S. want to make more toys, more clothes, more computer parts?
The way forward is for the U.S. to do what it does best, innovating, invention, being ahead of the world development curve. The U.S. should work with China to provide for a safer more prosperous world. And if China wants to do everything for cheaper, the U.S. should seize that opportunity.