RMB Revaluation and Repercussions

Over the last six years, the appreciation of the Chinese Yuan has been as reliable as a clock. Since China tweaked the Yuan-Dollar peg in 2005, it has risen by 28%; so 4.5% per year. If you take out the two year period from 2008-2010 during which the Yuan was frozen in place, the appreciation works out to be about 7% per year. No other currency has had such a consistent, solid and risk-free performance . The Economist describes our global economy to be “sicker than a man with a bellyful of bad oysters” and the remedy is definitely not a trade war. Despite China’s objections, on October 11th, 2011, America’s Senate passed the Currency Exchange Rate Oversight Reform Act, which would allow any “fundamentally misaligned” currency to be labelled a subsidy subject to countervailing duties. Guess which large Asian nation the senators had in mind?

Recently, the White House has been really turning up the heat warning that Americans were growing increasingly frustrated and impatient over what they see as unfair Chinese trade and currency manipulation, as stated in an article in the Economy Watch. Supporters of the legislation say it would create new jobs and boost the U.S. economy, but China, and experts in the United States say it could trigger a damaging trade war.

What would the repercussions be for the American economy?

China argues that it has already allowed the yuan to appreciate significantly, realizing gains of about 40% in effective terms since China unpegged its currency to the dollar in 2005. Chinese President Hu Jintao said that the US’ trade and employment issues, trade deficits, high unemployment rate and other economic troubles cannot be blamed on the Chinese yuan’s exchange rate, but rather, these are structural problems that will not be solved by even a major appreciation of the yuan, stressing instead the need for cooperation rather than confrontation between the world’s two biggest economies.

Are there Winners and Losers?

If we consider the appreciation of the RMB from an economic perspective, it’s safe to say economists generally frown upon the use of polices like trade protection and consider subsidies as a “beggar-thy-neighbor” policy strategy that creates tension, in this case, between China and many of its trading partners who view China’s currency as undervalued, saying they promote economic development in China at the expense of growth in other countries. This causes an interruption in market forces by distorting the efficient distribution of resources. Thus, a fixed or managed float exchange rate whose level is not adjusted when economic conditions change is considered a distortion.

If China and the United States (and the global economy of course) aimed for a more efficient allocation of their resources, they would have to consider adopting a more market-based currency, creating a win-win situation for everyone. If we consider the policy perspective, it could be argued that China’s current undervalued currency produces economic “winners and losers” in both countries, and an adjustment to that policy would create a new game, resulting in a new set of economic “winners and losers.” Although numerous factors affect global economic growth and trade flows, let us assume that an appreciation of the RMB produces a significant change in trade. What would the effects be on the U.S. economy?

Effect on American Exporters and Import-Competitors

When exchange rate policy causes the RMB to be less expensive than it would be if it were determined by supply and demand, Chinese exports tend to become relatively inexpensive, and U.S. exports to China become relatively expensive. As a result, U.S. exports and the production of U.S. goods and services that compete with Chinese imports decrease. What happens then? The trade deficit rises which in turn reduces aggregate demand in the short run. So a market-based exchange rate could actually boost U.S. exports and provide relief to U.S. firms that directly compete with Chinese firms. THis is the line of argument that politicians in Washington have assumed.

What is the effect on American Consumers and Producers?

According to economic theory, a society’s economic well-being can be measured by how much it is able to consume as opposed to how much it is able to produce. An undervalued RMB lowers import prices from China, allowing the United States to increase its consumption due to an improvement in the terms-of-trade. Beacuse changes in spending are only temporary, the long run effect of an undervalued RMB is an increase in the purchasing power of U.S. consumers.

Imports from China include consumption goods as well as finished goods, as U.S. firms import capital equipment and inputs from China. The prices of these U.S. products are lowered by an undervalued RMB, which increases their output and makes these firms more competitive on an international level. An appreciation of China’s currency could raise prices for U.S. consumers, lowering their economic welfare, meaning they have less money to spend on other goods and services. What is the final result? Firms that use imported Chinese parts face higher costs and become less competitive.

Overall effect

Let’s move on and consider the net effect all this could have on the American economy. Economic theory states that an undervalued RMB neither increases nor decreases aggregate demand in the United States. On the contrary, it leads to a compositional shift in U.S. production, moving away from U.S. exporters and import-competing firms and toward the firms that benefit from Chinese capital flows.

Let us take a look at this interesting example: since the 1980s, the U.S. trade deficit has been known to rise as unemployment falls (and the economy growing) and conversely fall when unemployment rises (and the economy contracting). In addition, in 2006 the U.S. current account deficit peaked at 6.0% of GDP, when the unemployment rate was at 4.6%, but has since been in decline, hitting 2.7% of GDP in 2009, when the unemployment rate was 9.3%.

What does Beijing have to say and what are the advantages for China?

If we take into account China’s perspective, according to an analysis of China’s currency by the Congressional Research Service, “China’s Currency: an Analysis of the Economic Issues”, Chinese officials argue that their currency policy is not meant to favor exports over imports, but to use currency stability to foster economic stability. The government’s goals of using Chinese suppliers and exporters as a way of providing jobs to Chinese workers and to attract FDI in order to gain access to technology and know-how is reflected by this policy. The Chinese government has stated on numerous occasions that currency reform is a long-term goal which must be implemented gradually. However, in recent discussions, President Obama and other U.S. government officials have continued to strongly condemn China’s continued currency manipulation. China has responded by pointing out how difficult an immediate RMB appreciation would be in a country where 40 million people live on less than US $1.00 a day despite the incredible performance of Chinese Manufacturers. Economic growth is critical to sustaining political stability, and so implementing policies that might disrupt the economy and cause widespread unemployment is not at the top of China’s to-do list. China rejects assertions made by some economists that a sharp appreciation of the RMB is fundamental to boost global economic recovery and that its currency policy undermines the global economy. Beijing instead counters that continued promotion rapid domestic growth is the most significant policy China can undertake to promote global economic recovery.

It has been noted by Business Standard that Chinese imports have risen rapidly in recent years, increasing by 38.8% in 2010 (over the previous year) and by 29.5% during the first five months of 2011 (year-on-year basis). It is believed that the rapid growth in imports actually proves that the currency policy does not restrict trade nor does it promote Chinese economic growth at the expense of other countries.

Conclusions: Potential Outcomes

China imports petroleum, technologies, machinery and skills. It is the biggest consumer of such commodities as aluminium, coal copper and it is the second biggest consumer of oil after the U.S. As the prices of these, particularly the natural resources and labor, continue to increase, an appreciated RMB could do much to derail monetary stability though it equally could go a long way towards easing inflationary pressures. A stronger RMB together with a loosening of government control on capital outflows would prove to be economically rewarding when investing abroad. At the current status quo, Chinese firms that avoid investing abroad typically do so because they feel threatened by a potential further depreciation of their currency that may not be able to produce sufficient return.

Alternatively, if the RMB appreciated it could boost U.S. exports and the output of U.S. producers who compete with the Chinese, while alternatively harming the industries that have benefited from a comparative advantage in the current state of affairs. The U.S. bilateral trade deficit would likely decline (but not necessarily disappear). China is a country with a high savings rate, and the United States is a country with a low saving rate; it is not surprising that their overall trade balances would be, respectively, in surplus and deficit. Many economists believe that these trade imbalances will persist as long as the underlying macroeconomic imbalances persist, and a revaluation of the RMB would do little to fix these structural difference.

At the bilateral level, it is not unusual for two countries to persistently run an imbalanced trade, even with a floating exchange rate. If China can continue its combination of low-cost labor and rapid productivity gains, which have been reducing export prices in yuan terms, its exports to the United States are likely to continue to grow regardless of the exchange rate regime, as evidenced by the 21% appreciation of the RMB from 2005 to 2008, which did not lead to any reduction in the trade deficit over that same period. It goes without saying that there is no guaranteed solution to eliminating the current trade deficit.

Image Credits:

• Image: renjith krishnan / FreeDigitalPhotos.net
• Image: renjith krishnan / FreeDigitalPhotos.net
• Image: renjith krishnan / FreeDigitalPhotos.net
• Image: digitalart / FreeDigitalPhotos.net

• Melanie Hirsch- CPG Marketing Intern