China’s US Dollar Peg, Mercantilism Redux, Part 3

Published on January 2nd, 2012 | by

Photo courtesy: Consulate of the People's Republic of China, Chicago

Longstanding government fiscal and monetary policies are fundamental contributors to the global imbalances that have built up, and as recently as 2008-2009, broken out and all but tore down the as yet prevailing global financial and economic order.

Parts 1 and 2 of this series examined China’s foreign exchange rate policy and how it contributes to the accumulation of structural imbalances, making the argument that it’s past time for China to graduate to a floating exchange rate currency management system and open up its domestic financial markets.

In this third, final installment, recent China-US trade and foreign exchange rate figures are examined in light of China’s fixed, or semi-fixed, rate currency management system, which pegs the value of the yuan to the US dollar. Also examined are arguments from economists and analysts who support and contend that China should continue to maintain its dollar peg.

Global Trade Imbalances – Still Growing

The growing and increasingly global economic imbalances and strains caused by China’s current policies are apparent in light of other recent US national accounting statistics. The US current account deficit – which totals trade in both goods and services – rose to $470.2 billion in 2010, while China’s 2010 current account surplus grew to $306.2 billion. The U.S. trade deficit with China in goods alone hit a record high of $273.1 billion.

If China maintained a floating rate foreign exchange system, that should have led the value of the yuan to increase against the value of the US dollar. While the yuan has indeed risen in value against the dollar, its appreciation has been ‘managed’ by the Chinese monetary authorities. Resisting repeated calls to move to a floating exchange rate system, China’s State Policy Committee in 2005 said it would enact a “managed float” that would result in a gradual appreciation of the yuan. Recent signs indicate that this policy has been rescinded in light of recent economic weakness, the result being that China’s now holding the line against further appreciation, however.

China’s currency did appreciate against the dollar – nearly 20% between 2005 and 2008, but economists contend that it’s still undervalued by as much as 40%. And it’s become evident to many economists that China shifted back to a fixed exchange rate policy to prevent its export markets from collapsing during the global financial crisis.

CFR article authors Roya Wolverson and associate staff writer Christopher Alessi note that the nonpartisan Congressional Research Service cited the sharp increase in China’s foreign exchange reserves from $403 billion to $1.5 trillion between 2003 and 2007, and a US trade surplus totaling $268 billion in 2007 as clear indicators of imbalances in global trade and misaligned foreign exchange rates. In addition was the 2010 increase, to around $3.2 trillion, in China’s foreign exchange reserves, though its trade surplus narrowed to a a mere $183.1 billion.

“Chinese authorities did not announce an official change in policy during this period. Instead, experts ‘infer it from the fact that the rate hasn’t moved,'” US Council of Foreign Relations’ (CFR) Adjunct Senior Fellow for International Economics Steven Dunaway was quoted as saying in an updated November 2011 article on CFR’s website.

Other economists and experts cite a number of reasons why China shifting to a floating exchange rate won’t do much to alter the chronic US trade and current account deficits. Stanford University professors Robert Staiger and Alan Sykes say that not only would it be very difficult to prove China manipulates its currency to the detriment of other economies in violation of WTO policy, they say that currency devaluation does not alter trade balances in the long run. If that were true, or at least believed to be true by Chinese monetary authorities, then currency devaluation would be a way for Chinese leaders to address international demands at little or no cost.

The CRF authors also cite a 2010 paper in which analysts Yuqing Xing and Neal Detert used the supply and value chain of Apple’s iPhone to illustrate how globalization “dilutes the relationship between exchange rates and US-China imbalances.” The paper’s authors point out that China is the last “assembly point” for a chain of iPhone components sourced from the US and other countries, yet the full value of exported iPhones is credited to China in trade statistics. Well and true enough, but at the end of the day, what still matters is the amount of foreign currency reserves being accumulated irrespective of accounting conventions. And that numbers continues to set new records.

A Multilateral Problem

Morgan Stanley Asia chairman Stephen S. Roach, they also note, says that America runs chronic trade and current account deficits with 87 other countries, some, including Saudi Arabia, that also peg their currencies to the US dollar. True enough, it is a multilateral problem, but China is the world’s second-largest economy with by far the largest trade surplus.

China has the resources and size to develop a healthier, much more balanced economy by focusing on stimulating domestic consumption and by opening up international investment opportunities to Chinese savers – companies and individuals. That would go a long way toward a re-balancing of worldwide flows in trade and investment.

Chinese leaders strive very hard to assure their place at the “adults” table in international assemblies and organizations. Their size, success and international aspirations should require that they play by the same rules as the “big boys” when it comes to foreign exchange, trade and investment as well.

Roach contends that it’s Americans’ chronically low rate of savings is the root of the problem. Again, true enough. That, combined with an expansionary US monetary policy and fiscal policy focused on debt-fueled consumption, are important factors in US trade and current account deficits. And that’s a problem that could, and should, be addressed by changes in tax and monetary, as well as private sector bank consumer lending policies.

While agreeing with these arguments, Chinese officials also point out the risks a yuan revaluation and floating exchange rate system would have – mainly a sharp slowdown in manufacturing and industry, concomitant drops in employment and heightened social instability. How well do these arguments hold up?

If Chinese authorities did allow the yuan to float and its value did rise against the dollar, the Chinese would have that much more international buying and investment power. Of course, the authorities would have to loosen or eliminate regulations to allow that to flow more freely both inwards and outwards, but that would support efforts to stimulate domestic demand and consumption.

And since so many US and European companies already manufacture so much in China, that demand could take up the slack created by a drop-off in Chinese exports. It would also increase imports, which would make the economy more balanced, but it may well not have as great an impact as many expect given that so many US manufacturers already source materials or have Chinese subsidiaries.

Adopting a strategic combination of interrelated, mutually supportive measures such as these would also stimulate domestic investment and realign foreign exchange rates and money and investment flows. Large parts of China lack adequate infrastructure and services. It could be a boon to many, many millions of Chinese, who in largest part, haven’t participated to any great degree in the two decades and still running economic boom times.

About the Author

I've been reporting and writing on a wide range of topics at the nexus of economics, technology, ecology/environment and society for some five years now. Whether in Asia-Pacific, Europe, the Americas, Africa or the Middle East, issues related to these broad topical areas pose tremendous opportunities, as well as challenges, and define the quality of our lives, as well as our relationship to the natural environment.