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Essay Number 23
August 9, 2003 

To Revalue or Not to Revalue,
That is the Question for China's Leaders

by Satya J. Gabriel

This is an early draft of an essay written for the inaugural issue of China Now (successor publication to Beijing Scene, which was the widest circulation English language publication in China until the government shut it down.) See China Now, Vol. 1 Issue 1, p. 21, for final version.

Why do top U.S. economic officials, such as Fed Chair Alan Greenspan and Treasury Secretary John Snow, want their Chinese counterparts to revalue the yuan (renminbi)? American officials and a wide range of American economists argue that the yuan is undervalued vis--vis the U.S. dollar (to which the yuan is pegged at a rate of approximately 8.28 yuan per dollar). The basis for their argument that the renminbi (RMB) is undervalued is the very large trade surplus that China has with the United States and the concomitant buildup of dollar based asset reserves of China's central bank, the People's Bank of China (PBOC), and other financial institutions. China has accumulated about $350 billion in foreign-currency reserves and over $122 billion in U.S. government bonds. In other words, China is using its trade imbalance with the United States to become one of the biggest creditors to the U.S. government (although this is only possible because the U.S. government is currently suffering from a form of ADD -- American Deficit Disorder). This mutual dependence creates unique financial risks for the United States and provides the Chinese government with a significant amount of leverage over the U.S. government.

And there's the rub. 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 are more than three and a half times those 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 decided it didn't want U.S. government bonds anymore and dumped its holdings onto the market the impact on bond prices (and interest rates) would be quick and devastating to the U.S. economy. There's 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, D.C. as the only real potential rival to U.S. global hegemony.

This being the case, it is not difficult to understand why it might be of concern to policy makers in the United States that China is becoming such a huge creditor nation. But there are other reasons for U.S. government officials, especially Fed Chair 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. When was the last time an American political leader, whether elected or appointed, stood up and said, "The economy is in the dumps because I screwed up. It's my fault that millions are out of work." That's not the prescription for a long political career. It is much better for one's career to divert attention to other evils that are behind the economic woes. It was not that long ago that the primary target of official scapegoating was Japan. It was the Japanese who were taking good American jobs. And even more recently it was the Mexicans. But now there's 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, headed by Alan Greenspan, 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 might have been anticipated by Fed officials who had come to believe all the rhetoric about what fantastic economic planners they were. After repeatedly lowering interest rates and jawboning the Fed has done little more than stimulate a housing boom (and growing speculative bubble in housing prices).

The fact that U.S. policy makers might 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 indicate 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 price exports to the U.S. These low priced exports displace higher priced American goods, inventories buildup 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 very obvious problems 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 shirts, 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 the ire of 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, live better, than without these low cost imported goods. The money saved on goods made in China may, in fact, result in higher purchases of the more capital (and knowledge) intensive goods manufactured in the United States, not to mention stimulating 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 (bureaucratic) 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 a lot 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. A worse 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 probably do the right thing and drag their feet on the question of revaluation, much less 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 any time soon.

The irony of all this debate about revaluing the RMB is that it has probably added impetus to American and European investors and transnationals to speedup 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. At least this is the case as long as those expectations are not met.

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