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.

Washington may have forgotten how its silver policy affected China in the 1930s, but Chinese policymakers remember, and they do not want to undertake another massive revaluation that could produce domestic deflation and cripple exports, leading to massive job losses. Such caution is especially understandable given the experience of other Asian countries that heeded international advice. When China's neighbors followed the International Monetary Fund's prescription to liberalize their financial systems during the 1990s, they experienced a major crisis because of their large current account deficits and huge dollar debts. China was actually on the road to a freely floating exchange rate and full convertibility just prior to the East Asian financial crisis of 1998. But after the meltdown throughout the region, Beijing was convinced that in a world of hedge funds and rampant speculation, it was safer to protect one's currency.

In the aftermath of the Asian crash, there was a risk that China would devalue the yuan, leading to a cascade of other devaluations throughout Asia, which would have deepened the crisis. Instead, China took a long-term view. It exhibited regional leadership and left the yuan alone. After all, it did not really need to take the risk. In fact, due to forced devaluations elsewhere in the region, China's real exchange rate actually appreciated by 30 percent during the crisis. Nevertheless, its exports remained resilient due to high productivity growth. As late as 2002, Beijing continued to resist the temptation to devalue, even though doing so would have been to the country's immediate export advantage. China was unafraid to stand alone; its steadfastness proved to be its first act of global citizenship in the postwar period.

Traditionally, it has been China's banks that have opposed currency revaluation, out of fear that it might damage the financial sector. But today, resistance to a more flexible exchange rate is also coming from interest groups in China, such as industrialists and farmers, who fear losing their competitive edge in the export market. China depends on manufacturing employment for 109 million jobs -- compared with the United States' 14 million manufacturing jobs -- and the government is naturally concerned that a significant exchange-rate appreciation could reduce manufacturing employment in China: export prices would rise, and markets for cheap Chinese products abroad could dry up. Some textile companies in the manufacturing hub of Guangdong Province are moving factories to Cambodia and Vietnam because of rapidly rising wages and uncertainty over Beijing's exchange-rate policy. Chinese farmers are also worried in the longer term about international competition now that World Trade Organization agreements have made the Chinese market more porous to imports. These farmers are a potentially powerful constituency given that two-thirds of China's population resides in the countryside and increased imports would have a major impact on the developing rural economy.

CHINA'S GLOBAL TRADE DEFICIT

Unlike many of their counterparts in Washington, officials in Beijing understand that U.S.-Chinese trade imbalances are a function of something much greater than exchange rates or even bilateral trade. Production has become so globally integrated today that very few manufactured goods are actually made in a single country from start to finish. Unlike Japan, for example, China does not have a vertically integrated domestic economy that can produce an entire product line from raw materials to finished goods. Instead, China is the last stop on the global assembly line. It imports components from other Asian countries, completes the manufacturing process, and then exports finished products to the United States. In 2003, intermediate goods produced by companies in Japan, Singapore, South Korea, and Taiwan accounted for 34 percent of all Chinese imports, compared with 18 percent in 1992 -- and the percentage is probably several points higher today. Also, because China serves essentially as a finishing shop, barely 20 percent of the value of the products it exports is actually captured by the Chinese economy. As a result, although China has a trade surplus with the United States, it has a trade deficit with the rest of Asia. In fact, China's trade deficit with East Asia grew more than threefold, from $39 billion to $130 billion, between 2000 and 2007, just as China's trade surplus with the United States increased nearly threefold, from $90 billion to over $250 billion, during the same period.

As these figures make clear, far too much emphasis has been placed on bilateral issues between the United States and China -- rather than on trade imbalances as a global issue. For one thing, they suggest that being on the short end of a trade imbalance is not necessarily an economic liability. China supporters in the United States, including the Club for Growth and a number of academic and Wall Street economists, have warned against anti-China protectionism precisely on the grounds that the Chinese trade surplus is not necessarily such a bad thing for the United States. Ballooning corporate profits have given China a savings surplus, which it recycles into U.S. Treasury securities as part of its foreign exchange reserves. U.S. firms have also shared in this boom: their profits from business in China rose to over $4 billion this year -- 50 percent more than a year ago.

Furthermore, as a recent study by the Hong Kong Institute for Monetary Research (the think tank of Hong Kong's de facto central bank, the Hong Kong Monetary Authority) shows, the yuan's value is a function of China's overall trade balance, not simply of its surplus vis-à-vis the United States. In fact, the HKIMR researchers argue, currency appreciation would not have the expected effect of decreasing China's exports. It could actually have the opposite effect by decreasing the cost of the imports China needs in order to create finished goods for export to the United States and Europe.

BEYOND REVALUATION