Let the renminbi rise

Even though US President Barack Obama’s trip to China yielded no results as far as appreciation of the renminbi goes, the EU is now getting ready along with other nations to exert pressure on China to revalue its currency so other currencies do not suffer on account of uncompetitive exports.

The Brazilian Real has appreciated 25.49% since the beginning of 2009, the Chilean peso 14.06% and the Argentine peso 10.95%. But the Chinese yuan stayed completely on par with the dollar in 2009.

Structural imbalances

The imbalances existing in the world are structural in nature, which is why they have been so persistent. How can Germany and China continue to run large current account surpluses when countries like the US, the UK and Spain experience their deepest domestic recession in decades?

Attempting to address these structural surpluses using cyclical policies can only end in trouble.

Low interest rates created the private debt crisis. Loose fiscal and monetary policies will only result in a public sector debt crisis.

Even the use of cyclical policies in the current account surplus countries themselves is not a long-term solution and will likely result in asset bubbles. Structural changes in economies (by increasing domestic spending) and greater flexibility in exchange rates are required for a permanent solution to global imbalances.

The Chinese trade authorities believe it is ‘unfair’ to expect the renminbi to rise when the dollar’s decline was making US goods more competitive. However perplexing this is for politicians or investors who are long on renminbi forwards, policy shocks are not what China needs. Exports dropped almost 14% in October, the 12th straight month of decline. Behind the bluster, policymakers are terrified of what the economy looks like without full state support behind it. Investment in fixed assets accounted for almost 95% of GDP growth in the first three quarters. Of that, ‘government-influenced’ investment was almost half by CEIC/World Bank estimates. Until Beijing gets a clear view of unassisted growth, external pressure to revalue will be the least of its worries.

China’s current account surplus would still be over 5% of GDP in 2010. As long as a current account surplus of this magnitude persists, the expectation of renminbi appreciation is bound to remain strong and will surely lead to significant ‘hot money’ inflows, which contribute to large and persistent FX reserve accumulation despite potentially narrowing current account surpluses. And large FX reserve accumulation will constitute a major challenge to monetary policy implementation, namely the loss of monetary policy independence.

Multinational corporations in East Asia have established value chains by slicing up production processes and allocating the production blocks across countries in the region based on relative endowments of capital, skill, labour and infrastructure. As MNCs increase their presence in Asia, they procure more from local firms. This leads to the formation of industrial clusters, and local engineers and skilled workers begin migrating among firms and sectors. They bring their accumulated human capital with them and disperse it across the economy, promoting technological assimilation and productivity growth.

The major share of the international output of notebook PCs is produced in the Yangtze River Delta by Taiwanese Original Design Manufacturers (ODMs). These manufacturers form part of a network that includes branded firms such as HP, Apple and Toshiba, suppliers of key parts and components, producers of basic industrial materials, and makers of operating systems and CPU. Local Chinese firms supply connectors, batteries, switches and displays, and are also active in molding, casting, forging, plating and module-assembling. Both digital and human networks enable PC producers to react efficiently in real time to changes in consumer preferences and technology. Firms assembling notebook PCs have also kept inventories lean by processing 98% of the orders within three days.

As private demand in the US, Europe and Japan fell during the crisis, exports produced within regional production networks collapsed. This, in turn, caused output and employment throughout Asia to plummet. Signs are emerging that East Asian production networks are reviving.

While many Asian countries have adopted greater exchange rate flexibility, China has returned to a de facto dollar peg. Exchange rate stability between Asian currencies is essential for the uninterrupted flow of parts and components within regional production networks. Within East Asian production networks, however, both theoretical and empirical evidence indicate that exchange rate volatility deters trade. This effect arises because the service link cost for production blocks separated by national borders is an increasing function of risk and uncertainty.

Exchange rate volatility increases risk and uncertainty.

Since Asian economies not only cooperate within production networks but also compete in third markets, China’s exchange rate peg puts pressure on other countries in the region to prevent their exchange rates from appreciating. Exchange rate appreciations across Asian supply chain countries are necessary to reduce global imbalances. A fixed renminbi makes it harder for the huge surpluses generated within East Asian production networks to lead to a generalised appreciation of Asian currencies.

Dollar vs Euro, Yuan and Yen

The bilateral deficits of the US have been fairly stable with Europe and Japan for the period 2002-08, with a sharp inflexion during the collapse of US demand in Q3 2008.

After their sharp contraction in the wake of the Lehman bankruptcy, Chinese exports to the US are apparently on the verge of returning to their previous levels! This is especially so if we consider the seasonal nature of the bilateral deficit, culminating in October of each year, due to the importation of toys by the major American department stores in preparation for the holiday season.

The dollar must decline relative to other currencies to make US products more attractive to foreign buyers and to cause Americans to substitute US goods and services for imports. Without incentive to increase exports and reduce imports, the rise in domestic spending will just lead to US economic weakness and rising unemployment. That is why the recent decline in the dollar relative to the euro, the Yen and other currencies is a natural and desirable part of the process of reducing the US trade deficit and shrinking global imbalances.

Till mid-2005, the Chinese yuan was pegged to the dollar. The Chinese were running huge trade surpluses with the rest of the world, yet their currency remained tied to the dollar and therefore was very cheap. As a precondition to joining the WTO, China was made to commit to working towards opening up its markets and floating the yuan. After immense political pressure, China begin to gradually revalue the yuan; however, as the yuan appreciated, there were huge incentives for Chinese companies to borrow in dollars and either invest back in their own market or just hold yuan—and take the appreciation. The cost of borrowing in dollars was more than made up by the rate of appreciation of the yuan. So, it was just a pure carry trade and it grew to be very large.

Going into the summer of 2008, the steadily appreciating yuan began to cause problems for the Chinese.

Investors and speculators piled into this huge carry trade trying to capitalise on the managed appreciation of the yuan; but there was growing uneasiness amongst many Chinese manufacturers of lower value-added items like toys and apparel, who could not compete with the Vietnamese or other low-cost countries with even cheaper labour. Large bankruptcies ensued. Accordingly, the Chinese central bank reversed direction and started pegging the yuan to the dollar in the week of July 17, 2008.

Unfortunately, since then the Chinese government has kept the yuan pegged at 6.82 renminbi per dollar. With the dollar falling relative to other major currencies, the fixed exchange rate of the yuan relative to the dollar has caused the Chinese currency to fall relative to the euro, Yen and other currencies. The trade-weighted value of the yuan has therefore been declining, making Chinese exports more attractive and foreign goods more expensive in China.

China’s policy of keeping the renminbi weak means that the dollar must decline more rapidly against the euro, Yen and other currencies to achieve the same overall trade-weighted fall of the dollar. China’s weak renminbi policy, therefore, not only prevents remedying China’s large current account surplus but also reduces Europe’s exports.

A solution to this impasse would be for China to abandon its de facto dollar peg and adopt a regime characterised by a multiple-currency, basket-based reference rate with a reasonably wide band. In this case, there would be more stability between the renminbi and other Asian currencies. In addition, exchange rates in the region would be able to appreciate together in response to regional trade surpluses.

However, China’s labour-intensive exports and thus employment in these industries are sensitive to exchange rate appreciations. On the other hand, exchange rate appreciation would reduce the need for Chinese and other Asian central banks to continue accumulating US Treasury securities. Private and social rates of return are much higher for investments in education, healthcare and clean water than for investments in the US securities. An appreciation of the renminbi would also allow Chinese consumers to purchase more of the manufactured goods that were previously exported to developed markets. A stronger renminbi would thus allow Chinese workers to enjoy more fruits of their labour while reducing their dependence on the West for end-demand.

China’s policy of expanding domestic spending while depressing the renminbi so far has consistently caused its economy to overheat, particularly its manufacturing sector. Allowing the renminbi to rise would shift demand in China from manufacturing to services and will prevent inflation.

A stronger renminbi would thus reduce China’s domestic imbalance and therefore, correct global imbalances.