Re-valuation of the Chinese Renminbi
Written by Madmark   
Saturday, 13 February 2010 12:33


There's an issue that troubles economists, politicians, conspiracy theorists, and concerned everyday Americans alike: how are we affected by the Chinese currency exchange rate policy?  It is argued that China artificially forced its currency low to make its exports cheap to the rest of the world, and is expected that the Renminbi will be pushed to raise its value.  (Note: If you truly believe it, you should buy a boatload of RMB now and sell it when the rates are adjusted!)

We often hear politicians telling us how we are getting hurt, but exactly how?  An Econ 101 student can explain to you that if the USD-RMB rate is high, we can consume cheap imported goods.  I.e., we ought to thank China every time we shop at Wal-Mart.  At the same time, we can't dismiss our exporters, as the Chinese import less from us because our good are expensive!  So which side of the story is stronger? 

I have recently discussed this topic with two academic researchers.  Below are their responses.  Byron Tsang is with the Virginia Polytechnic Institute and State University specializing in International Finance.  Michael Bar is with the San Francisco State University specializing in Growth Economics.

1.) Why do countries peg against the USD or EURO?

Byron Tsang: There are two main reasons for countries to peg their currencies to a major currency like the USD or Euro.   The first benefit of having a fixed exchange rate is the reduction of risk.  For an exporter in China to do business with an importer in the US, the exporter may need to convert the USD received from the US importer into RMB.  If the exchange rate is fixed, the uncertainty in the transaction is greatly reduced: you know how much 1 USD will be worth tomorrow.  But if the exchange rate is flexible, the amount that you will receive in RMB eventually is unknown.

Pegging to a major currency like the USD also prevents the central bank from pursuing reckless monetary policies, and therefore keeps inflation and expected inflation stable.  Under the fixed exchange rate, the country needs to keep its interest rate align with that of the US to make the two currencies equally attractive.  If not, as in the case of China, the country has to keep the fixed exchange rate by policies like capital control or sterilization (i.e. buying and selling its currency in the market).  As a result, a fixed exchange rate greatly restrains what the central bank can do.  For example, the central bank cannot print a large amount of money and still keep its fixed exchange rate intact.  

Michael Bar: One reason for pegging the domestic exchange rate to some stable currency is to lower domestic inflation. If a country pegs it’s currency to the USD or Euro, it essentially restricts the growth rate of its own currency. This can be seen as importing the monetary policy of the U.S., or hiring Bernanke as your own central banker. Argentina and Israel implemented a currency peg to lower inflation, and the degree of success is arguable. I believe that China pegged its currency to the USD in 1995 – 2005 to lower inflation. Indeed, the next figure shows the inflation rate in China and the exchange rate vs. USD.

Another reason for pegging is to maintain stable exchange rate. Large movements in the exchange rate, especially during financial crises, make it hard for individuals and firms to plan for the future. For example, if a Chinese student goes to study in the U.S., and suddenly the Yuan depreciates sharply, his tuition cost will rise as well.

 
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2.) Does the U.S. get "hurt" if the others peg against the USD?

Byron Tsang: Let’s focus on the impact on the US if a large country like China pegs its currency to the USD (the impact of a small country, if any, would be small), and also assume that the foreign currency is undervalued like the RMB.  Some people in the US do get hurt, as cheap labor from China essentially replaces some low-wage, low-skill jobs in the US.  For example, toys are now produced cheaply in China and there is little demand for toy makers in the US.  For someone who has spent 20 years making toys in a US factory, competition from China will greatly reduce the value of the toy-making skill.  It explains why unions of manufacturing workers are the strongest force supporting the “China bashing” regarding the RMB.

On the other hand, an undervalued RMB has been contributing to the low and stable inflation in the US during the 1990s and 2000s, and US consumers gain by enjoying cheap goods produced in China.  

Michael Bar: The pegging itself does not hurt the U.S., but the particular level at which the fixed exchange rate is set does have effect on the trade. Under flexible exchanger rate regime, the exchange rate adjusts to restore current account balance. For example, if the U.S. has trade deficit with China (imports of goods and services from China exceed exports of goods and services to China), this means that there is excess demand for Chinese currency, and under flexible exchange rates the Yuan should depreciate. Under fixed exchange rate this is not guaranteed. The central bank of China can issue more Yuan for Americans to buy Chinese exports, and in return U.S. gives China some dollar denominated assets: bonds, cash, real estate in the U.S., etc.

If the peg is at such a level that U.S. experiences trade deficit with China, this means that U.S. exports are expensive in China and imported goods from China are cheap in the U.S. This policy works as a tax on U.S. exports to China and does hurt exporting companies in the U.S. At the same time, American consumers enjoy cheap imports from China, and therefore benefit. Thus, some benefit while others are hurt.

3.) Is the RMB under-valued?

Byron Tsang: A quick answer will be yes: given the spectacular economic growth of China during the past 30 years the RMB should be a much stronger currency that it is now.  But there is a catch here: by pegging the RMB to the USD, the strength of the RMB is one of the main reasons why we do not see a big drop in the value of the USD since the financial crisis. 

Academic research is less certain about the undervaluation of the RMB though.  A recent research paper from the National Bureau of Economic Research points out that, given the amount of data we have, there is a huge amount of uncertainty over the conclusion that the RMB is undervalued.

Michael Bar: If we define a “correctly-valued” exchange rate to be the one that balances the current account with China, then the Chinese RMB is indeed undervalued.

4.) Does the U.S. gain if the RMB goes up to, say, 5:1?

Byron Tsang: Let’s define “gain” as a reduction of the trade deficit and more competitive US exporters.  Then the answer is no.  First, the dollar amount of trade balance with China will probably go up due to the low elasticity of demand.  For example, it may take a while for retailers and consumers to shift from toys imported from China to some cheaper alternative.  In the short run, the US will be buying slightly less from but paying more to China.  Second, facing the more expensive Chinese goods, the US importers will just buy from other countries with lower labor cost (e.g. Vietnam).  In both the short and long runs, the trade deficit of the US will not go down, and US exporters will not gain from such a policy (e.g. no positive effect on employment for the exporting industries).

Michael Bar: Exporting companies will gain, while American consumers will lose. If I travel to China this summer, I will definitely lose from devaluation to RMB to 5 per dollar.

5.) So, can a country gain by manipulating its currency-exchange rate policies?

Byron Tsang: There is a difference between pegging and “manipulating” a currency.  For the case of China, from 1994 to 2005 the RMB was pegged at a fixed rate to the USD, followed by a gradual revaluation, and pegged at a fixed rate again since the financial crisis.  Such a picture does not fit with the label of “manipulation”.   If what we mean by “manipulating” a currency is simply any action by the central bank to affect the value of its currency, then almost all countries in the world are to some extent “manipulating” their currencies: no currency is truly flexible and the exchange rate is one of the factors most central banks take into account when making monetary policy.

If “manipulation” simply means pegging a currency, then you may refer to the first question on its benefits.

Michael Bar: China is a developing economy with 39.5% of its labor force employed in agriculture. I believe that the Chinese government wants to turn the country into an industrial superpower. By keeping the RMB low, they are helping the industrial export-oriented sector, but at the expense of the Chinese consumers for whom imports are artificially expensive. This is an investment policy in the Chinese industrial future, which might benefit future generations but hurts some people in the current generation.

 

 
(Photo: cliff106)

 

    

 

Comments  

 
+20 # Gnomie 2010-03-08 01:41
Good read. Notice that it is the politicians using these kind of issues to gain popular support from voters. But I think the impact on our export industry is probably bigger than what Tsang said. In the short run there should be a "vaacum" effect since no one can replace chinese goods overnight. This will end up in people consuming other substitution and more expensive goods. The domestic industries might build up to some extent but I highly doubt it. We will simply have the same goods made in Mexico instead, although more expensive than China.
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+18 # PatLogan 2010-03-10 00:29
Yes, I agree that we will suffer in the short run if the Chinese adjusts the currency to the proper market value, say 1 USD to 5 RMB. However, that is much better than, say 5 years later, when the adjustment goes from 1:7 to 1:4. The hit will be overwhelming. It's just reality, we need to learn to deal with it.

The other part being being more self-sufficient. We are relying way too much on foreign imports. We should at least have the capacity to be self sufficient (at least temporarily) if needed and this is a good start.
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+13 # Jerry The Great 2010-03-13 12:25
If the goal is to ease the "hit," then we can simply enforce a mandatory savings regime (or people are smart enough to save) and consume less of the cheap goods. Use that money when the exchange rate adjusts. Or better yet, buy Chinese RMB and convert that back to USD when rates adjust.

I agree with the point about self sufficient, but it really is hard to grow everything yourself. It is simply not smart because the footloose cost is very high in most cases.
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-1 # Buy American 2010-03-24 14:45
I would be the first to give up on Chinese goods if that helps. But I highly doubt the others will follow suit, which makes the entire purpose meaningless.
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+7 # Jason 2010-04-25 14:26
Why are they complaining when we are getting cheap goods? I tell China to keep the "below" market price items coming if they are willing to. If I walk into Starbucks and they offer me coffee at 80% off, am I going to complain about it that they want to drive the other cafes out of business.

Sell crazy elsewhere!
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+15 # ItalianScholar 2010-03-17 17:36
Well, China is going to find is hard to resist the pressure on its currency policy. A suppressed currency will cause lots of damage once the peg is removed.

Latest report on the World Bank's "recommendation":
nytimes.com/.../18yuan.html
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