Reconsidering Revaluation

The Wrong Approach to the U.S.-Chinese Trade Imbalance

David D. Hale and Lyric Hughes Hale

From Foreign Affairs, January/February 2008

Summary:  Politicians in Washington are clamoring for currency revaluation in China to reverse China's trade surplus with the United States. But the trade imbalance is not the threat they make it out to be, and a stronger yuan is not the solution. Everybody should focus instead on properly integrating China into the global economy.

DAVID D. HALE is an economist and Chair of Hale Advisers LLC. LYRIC HUGHES HALE is Founding Publisher of www.chinaonline.com.

China's economy has grown dramatically in the last decade: it is more than twice as large as it was ten years ago. This spectacular rise means that Beijing can influence the global economy today in ways that would have been unimaginable in the 1990s -- a development that has led to widespread concerns in the United States. Many officials in Washington and small U.S. manufacturing companies allege that Beijing has deliberately undervalued its currency and manipulated markets in order to promote the growth of its exports.

Consequently, many U.S. politicians are clamoring for action to redress China's growing annual trade surplus with the United States, which currently stands at $250 billion. They assume that increasing the value of the yuan against the dollar will simultaneously decrease Chinese exports to the United States by making them more expensive and boost U.S. imports to China by making them cheaper. As the 2008 presidential election approaches, the U.S. Congress is actively discussing protectionist legislation and new tariffs that would punish China if its currency does not appreciate faster than the current rate of five percent.

But revaluation -- no matter how vehemently it is advocated -- is unlikely to achieve the desired result of reducing the U.S. trade imbalance with China. Taxation reform, the restructuring of the corporate and banking sectors, the gradual opening of capital accounts, and the encouragement of domestic consumer spending would each have a more measurable and lasting effect on China's current account surplus. There is also scant reason to believe that Beijing will accept the large-scale revaluation of 20 percent or more sought by certain members of the U.S. Congress. Such a policy could result in fewer exports, lost jobs, and capital flight to other emerging markets with cheaper labor costs, not to mention increased currency speculation and exchange-rate losses on hundreds of billions of dollars worth of U.S. Treasury debt now held by the Chinese government.

In addition, the trade imbalance that a revaluation of the yuan is supposed to fix is not the dire threat that many in Congress have made it out to be. The growing Chinese trade surplus has actually produced numerous benefits for the world economy and for U.S. corporations and consumers. It has handsomely rewarded U.S. companies, such as Wal-Mart, which have enjoyed record profitability as a result of low labor and production costs in China. Critics forget that China's central bank, the People's Bank of China, uses the surplus to buy U.S. debt, which benefits the U.S. economy. Furthermore, some 27 percent of China's exports are actually generated by U.S.-owned corporations, which pass on their savings to consumers back home.

Simply strengthening the yuan will not correct the U.S.-Chinese trade imbalance, much less bring China's dynamic economy into lasting equilibrium; at best, it is a flawed solution to an ancillary problem. The greater and far more critical challenge is to properly complete China's integration into the global economy. China is but one cog, and revaluation just one lever, in the complex machinery of international trade. Unfortunately, many U.S. politicians with little knowledge of economic theory, trade flows, or investment patterns have not grasped the intricacies of the Chinese economy and its place in the global marketplace. And so they seek a jingoistic, politically popular solution to a complex and multifaceted problem.

THE PERILS OF REVALUATION

This is not the first time Washington has sought to intervene in Beijing's monetary affairs. In the early 1930s, President Franklin Roosevelt's administration supported legislation to raise the price of silver in order to both garner support for the New Deal from western senators in silver-producing states and increase U.S. exports to China. But this proved to be a disaster for China, which was then on the silver standard rather than the gold standard. Unlike the rest of the world, China had experienced economic growth during the early years of the Great Depression due to low silver prices and rapid industrialization. The Silver Purchase Act of 1934 compelled China to revalue its currency, decreased its exports by almost 60 percent, and plunged the Chinese economy into chaos -- while failing to increase U.S. exports to China. In the twenty-first-century world of highly mobile capital, information, talent, and technology, similar policies of economic containment, such as those currently circulating in Congress, are even more likely to fail.

Nevertheless, Washington remains obsessed with China's exchange-rate policy. Labor unions and second-tier U.S. manufacturing firms insist that China has kept its currency artificially undervalued in order to boost its international competitive position. They point out that China has a trade surplus with the United States equal to nearly two percent of its GDP, compared with a peak of 1.2 percent for Japan in the 1980s, when the U.S. government last panicked about trade imbalances with Asia.

Washington has already taken punitive action. The U.S. Commerce Department shocked the financial markets on March 30, 2006, by announcing new trade measures against China's paper industry, potentially opening the door to many more attempts by U.S. companies to block Chinese imports. It introduced duties on Chinese paper imports because of allegations that the paper industry in China benefits from unfair subsidies, such as low tax rates and low-cost loans. This announcement broke with the 23-year-old U.S. policy of treating China as a nonmarket economy not subject to countervailing duties. Before this change, U.S. companies could only file antidumping cases against Chinese firms. The Bush administration's decision to pursue these sanctions reflects the new political mood inside the Beltway.