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.
YinYang says
@Allen,
Great article.
There was a recent historic lesson too – on the crazy problems Japan had to endure after being coerced to rapidly reevaluate the Yen by 200% against the USD. See “Professor Jiang Ruiping:”Revaluation of Japanese Yen, a historical lesson to draw: analysis”.”
Recently I asked a few Japanese friends about why they thought Japan loans so much money to the U.S. given Japan herself is so debt ridden. They all pondered a while and they replied unanimously, “Japan is forced to, ne,” with a sigh.
Since Japan is still an occupied country by the U.S., a lot of national policies can still be dictated by the U.S.. Forcing the Chinese government to alter the RMB may be helpful to U.S. strategies at the moment. But the U.S. really will have to give China incentive. Otherwise mileage may vary. Trade barriers can go up, and then such becomes matter of WTO.
YinYang says
NPR’s most recent article out on this topic:
“Lawmakers Target China Trade Policies For Jobs Woes.”
Perhaps there’s more sanity in America than we give her credit for – below is one of the most recommended comments beneath the article:
The ugly comments are plenty abundant too; here is an example:
Allen says
According to this NY Times article, some economists believe if the Yuan were revalued, half-million American jobs can be created over the next two years.
This is another example where politics has been raised to the level of economics.
Have the same economists here foreseen the financial crisis, the housing bubble, or the current recession?
Economics is a difficult and complex phenomena. There are few consensus over what a tax cut would do to the economy, much disagreement over how many jobs the Federal stimulus actually did save, and now we are expected buy that we can predict how much jobs can be created by a revaluation of the Yuan?
What will happen if the value of the Yuan is raised? Some jobs will probably “come back” (what jobs do you want from the Chinese?). But many other jobs will leave. Whatever the net balance, it is almost certain the overall well-being of Americans will probably decrease.
Why?
International trade presumably takes place so each country can take advantage of their comparative advantage. Even if one of China’s comparative advantages were their “suppressed yuan,” it is still a comparative advantage that China offers to the world at large. Removing one such advantage will lower overall wellfare of the system.
In the U.S., it will probably mean that inflation will rear its ugly. So will interest rates. In the 80’s, many people wanted to raise tariffs against Japanese cars. That probably saved some UAW jobs, but did it really lead to overall American well-being? Why do we trade anyways?
Will protectionism lead to increased welfare for Americans? If you really think so, I’ve got some beach front property in Arizona I’d like to sell you.
Joe says
The Americans are the craftiest and aggressive people on earth, trying to con/force other nations into doing what she wants!
r v says
When I was watching Comedian Jon Stewart’s “Daily Show”, I usually agree with his complaints about the politicians in US in “polarizing” US and generating extremism.
But then, I suddenly realized a subtle paradox that even Jon Stewart didn’t realize, when he said “who cares what the rest of the world thinks of us.”
He is correct that the rich and the powerful in US have too much power, and they are distorting the political debate in US for their own benefits, using their wealth and power to distort and polarize. Rupert Murdoch and the likes have no qualms about using their media resources to lie and cheat. (And this will likely degenerate US further and further.) That’s what the rich and the powerful do, if given the opportunity.
But if one steps back, one realizes, that US is like a rich and powerful member in the world. Consuming more, having more, and have the weapons to keep the poor out.
Is US not like a Rupert Murdoch in the world? asserting its interests without hesitation to get what it wants.
YinYang says
@rv
Indeed.
Madeline Albright made that famous speech during the Clinton administration: “We will act multilaterally when we can and unilaterally when we must.”
U.S. belligerence is balanced by how hard she wants to push people to an opposite corner. That’s really the only “check” against this awesome power.
r v says
1 thing I thought to mention to some of my American friends today is,
The effect of the dollar’s value is the consequence of globalization, not how China “manipulates” the dollar.
US spent decades trying to leverage its hold on the dollar, and its own dollar policies to advance its economic power in the world. (Doing so, by marketing the US dollar as the “global currency”.)
US achieved that goal amazingly well. US benefited from that in getting a lot of foreign investment, a lot of cheap loans. The world was backing US’s economic power.
But the inevitable (but unrealized downside) is, once other nations began to acquire massive amounts of US debt. the US dollar ceased to be a “US currency”. It has truly become a “global currency” being controlled by WHOMEVER holds the highest US debt.
In other words, US MUST swallow the bitter consequences of its own currency policies, because it has taken the benefits.
Like it or not, the DOLLAR is now really owned (controlled) by the debt holders. China, Japan, can significantly influence the DOLLAR, because the welfare of the Chinese and Japanese economy are in their own “dollar policies”.
For that reason, China has the right as part-owner of the US debt, to peg the dollar to Yuan, if necessary for its own economic welfare. (As much as a bank can foreclose and force sell a house, even if the bank merely owns part of value of the house. And the bank can force sell a house for much lower than its true value.)
In the Yuan valuation case, it comes down to, China is spending 7 Yuan to get $1 from its own banks to buy Item A, whereas US is complaining, China should be spending 7 Yuan to get about $2 from its own banks to buy 2 Item A. (Boiling down: China is spending only $1 for item A, where as it should be spending $2 for 2 item A’s.)
*So, I believe, it should be soon noted by China to US: “Your dollar is now OUR dollar. You sold your dollar to the world, we bought it, we can do what we want with OUR dollar.”
qingdao says
“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”
So is the “conversion rate” set between China and the U.S. such that “there is a sustainable balance of payments?” Or has China accumulated $2.5 trillion?
Allen says
qindao #8, I think what you ask is a valid quesiton. The currency imbalance is a result of 2 main things: 1. net savings difference between U.S. and China and 2. the flood of FDI from U.S. to China.
As I discussed in another article (which provides charts to make the discussion more succinct), the U.S. has a currency imbalance with the rest of the world starting three decades back. The imbalance is a result of the net savings difference between U.S. and rest of the world. The currency imbalance the U.S. has developed with China results as part of that imbalance.
China’s imbalance is also made bigger in addition by the direct FDI by U.S. companies to invest in China. Every dollar that is converted to the Yuan is counted in the currency imbalance even though the asset is still controlled by U.S.companies.
As for whether the above 2 phenomena are sustainable – probably not.
U.S. will have to start saving more. This means the U.S. will have to start living within its means – not way above its means. As long as the net savings rate between the two countries start to converge, the currency imbalance will starts correcting itself.
Also eventually FDI to China will have to cool. As China develops more, China will offer less opportunities for rampant growth. Some of those FDI will start to return, decreasing the currency imbalance. As China develops, and the U.S. opens its own market up for Chinese investment, many Chinese companies will also flock to the U.S. to invest, further decreasing that currency imbalance.
Allen says
In a comment with YinYang from another thread, I quoted WSJ as saying that the U.S. trade deficit with China is probably 30% lower than official figures suggest. The actual number may be lower as McKinsey just published a report where they estimate that for every $1 of export, China imports as parts on average $.40-$.55.
The problem with trade deficit calculations is that when China ships $1 of good to U.S., the $1 is counted as a deficit to China even though China have to import $.40-.55 worth of parts to make the $1 of good. The parts may be obtained from all over the world (including the U.S.!), but as far as U.S. figure is concerned, $1 is counted against China.
Here is a copy of the McKinsey article:
Allen says
Here is a short news blurb of China Central Bank’s Zhou take on what is out of balance with the global economic order.
Allen says
As we have discussed in this post (using the iPad as an example) (among others), the trade deficit against China is highly inflated.
But what about the U.S. currency deficit? As I discussed in a previous post making sense of the dollar and yuan, the currency deficit the U.S. has with China is a result of the difference in net savings rate between nations. China’s currency deficit is not a unique problem of China – but a systemic problem caused by abnormally low savings rate the U.S. has compared to the rest of the world (not just China). Hence in the making sense article above, I provided charts showing how U.S. currency deficits with the world has moved up with its decreasing savings rate, how China’s deficit has stayed relatively stable as compared with the deficit the U.S. has continued to rack up against rest of the world.
Even the folks at FT see this, and I hope are on the path to seeing the attack against China in causing an “imbalance” as a farce.
I did a few check myself. The conclusion seems about right.
South
Most interesting thing is South Korea – which Obama has explicitly singled out as having a balanced account of trade with U.S. Not only is S. Korea like China (around 5% of gdp in imbalance), but South Korea’s figures are dramatically undercounted while China’s is overcounted (again see post above on iPad).
TonyP4 says
First, no country including US has the right to tell other countries to appreciate their currency. The era of ‘you’re either my puppet or my enemy’ is long past and Obama is still living in the past glory. He blames China for all our ills, as he cannot fix our problems.
Keeping the Yuan low actually helps US’s consumers and US in buying wind turbines or HSRs from China at lower prices. Not to mention the huge loans from China. China does not want to withdraw the bad loans as they do not want to kill the goose that lays the golden eggs.
The major products of China and US are not the same, so there are no direct competitions. If we do not buy the products from China, most likely we’ll buy same products from Mexico or India. Hence, there is no job gain in US. These countries most likely are keeping their currencies low. $20 per hour just cannot compete with $2 per hour. China is better than the competitor in hospitability to business, good infrastructure, hard working, stable political system, potential huge internal market and educated labor.
Until China builds up its local market for its growing middle class, I do not see Yuan will appreciate by more than 10% a year, which could drive up a global recession.
A strong China is good for the world including US! China is just one part of the global economy. The other players are research companies from the west and the US, oil from Middle East and Africa, and commodities from Australia, Brazil… China only adds $4 assembly cost to the $150 iPod. Everyone benefits including the consumers in every country.
Our government tries to divert our attention from their failures in fixing our economy. China is a convenient scapegoat. A trade war would force China to dump US debts and drive up a global depression.
It was an error US and other country asked China to depreciate the Yuan during SE Asia crisis. China is not that dumb to be trapped like Japan and Japan suffered from the lost decades. US did not gain competitiveness on Japan’s products even the yen has been appreciated 50%!
Allen says
Another economist steps forward to say pretty much what I argued here.
http://blogs.wsj.com/economics/2011/01/07/harvards-feldstein-says-us-china-trade-gap-on-path-to-resolution/
YinYang says
Btw, on Chinese Foreign Minister Yang Jiechi’s recent press conference / QA session with journalists, he said that countries should not politicize trade.
Allen – maybe this articled reached him. 😉
jason says
I am no a Chinese but I think china is the most peaceful country of the world, what ever they are doing for the progress of their country is their right, no one have right interfere their internal affairs…
Allen says
Obama just had his 2012 state of union speech (may be his last one, who knows…)
He mentioned China many times – directly and indirectly.
Here is a good reaction. The conclusion this New Yorker article draws is the same as this post, written in 2010.
http://www.newyorker.com/online/blogs/evanosnos/2011/01/china-state-of-the-union.html