Sunday, October 4, 2009

The China Currency Conundrum

On October 15th, the Treasury Department will issue its Semi-Annual Report to Congress on International Economic and Exchange Rate Policies, in which the US Government officially determines whether its trading partners are engaging in "currency manipulation," as defined under US Law (Sections 3004 and 3005 of the Omnibus Trade and Competitiveness Act of 1988). In April, Treasury declined to deem China to be a "currency manipulator" - a bold reversal of President Obama's protectionist campaign rhetoric on the issue and a move I've applauded as the lone "free trade" action of the President's short tenure.

Most economists agree that China's currency (the Renmibi or RMB), despite appreciating about 15% against the Dollar since 2005, remains undervalued by around 10-15%.  US labor unions and some manufacturing groups steadfastly believe that that the RMB's undervaluation has given Chinese exports a competitive advantage in the US market and disadvantaged US exports in China, and thus is the key driver of the large US-China trade deficit.  They therefore have intensely lobbied the US government to label China a "currency manipulator" in the Treasury Report, to challenge China's currency practices at the WTO, and/or to make "currency manipulation" a "prohibited export subsidy" under US anti-subsidy (or "countervailing duty") laws.  The last of these demands would lower the standard for finding "currency manipulation" and essentially make every Chinese export to the United States subject to a countervailing duty equal to the amount of the currency undervaluation.  (Nothing like a 15% tax on all Chinese imports - including shoes, clothing and industrial inputs - to really jumpstart the ailing US economy!  Yikes.)

In anticipation of the October 15 Treasury Report, the currency protectionists are at it again, as Reuters reports:

U.S. steel and textile producers on Friday urged the Obama administration to get tough with  China over its currency practices, while other groups said Beijing was dragging its feet on promised trade reforms.

"The U.S. government should cite China as a currency manipulator and should support legislation that allows U.S. industry to defend itself and its workers against this predatory practice," said Cass Johnson, president of the National Council of Textile Organization.

He made the remarks at an Obama administration hearing chaired by the U.S. Trade Representative's office to examine how well China is complying with the market-opening commitments it made when it joined the World Trade Organization in 2001.

Obama disappointed manufacturing and labor groups in April when he decided against labeling China a currency manipulator, after indicating during last year's campaign that he would take that step.

The groups complain China deliberately undervalues its currency, giving it an unfair price advantage in trade....

Barry Solarz, vice president of the American Iron and Steel Institute, said Obama should "take far more aggressive action" against China by declaring currency manipulation an "actionable" subsidy under U.S. trade laws.

It should also "pursue legal action in the WTO (World Trade Organization) to protect U.S. rights," Solarz said.

The U.S. Chamber of Commerce said Washington should steer clear of any action on Chinese currency that violates WTO rules or invites Chinese retaliation.

But "China should move as quickly as possible to a system that allows market forces to determine the exchange rate" of its currency, the renminbi, said Jeremie Waterman, the business group's senior director for China.
The Chamber's remarks and efforts are a welcome counterpoint to the currency marauders' intense lobbying - any major offensive against Chinese currency practices would no doubt lead to a full-fledged trade war with the Chinese (dwarfing the Section 421 spat) and would cripple the US economy in the process.  However, the Chamber - and pretty much everyone else who rightly opposes overt hostility to China's currency policy - never challenged the underlying assumption, fueled by the usual Beltway conventional wisdom, that China's undervalued currency has actually been the major driver of the US-China trade deficit.

They should.

Respected economist and former Treasury official David Ranson certainly doesn't think that the conventional wisdom is correct and lays out the theoretical reasons for his stance in a 2007 WSJ op-ed:

It's a myth that deficits are created by currency misalignments. They are driven by the business cycle. In the late stages of a U.S. business-cycle expansion, as now, exports traditionally outgrow imports and the trade deficit narrows as a result. When that occurs, the dollar's foreign-exchange performance tends to improve with a delay of about a year. Symmetrically, after U.S. imports grow faster than exports, the dollar's foreign-exchange performance tends to deteriorate.
While Ranson has soundly criticized the theoretical underpinnings of the currency-deficit argument, a new study by Yang Yao and Jianwei Xu of the China Center fo Economic Research appears to undermine the concept's factual basis through an analysis of historical trade and economic data.  Here's Yao in a Forbes op-ed explaining his findings:

In an ongoing study of 39 countries for the period 1990-2006, Jianwei Xu and I examined various factors contributing to China's trade surplus with the United States. We found that China's disadvantage in finance vs. manufacturing can explain 40–50% of China's trade surplus with the United States. China's low dependency burden can explain another 24%. By contrast, the undervaluation of the yuan vs. the dollar explains less than 2%. That is, China's trade surplus with the United States is better explained by its low cost labor supply and limited consumer spending than the value of its currency.

The implications of our analysis are three-fold. First, so long as trade imbalances are a product of labor imbalances, the trade surplus will not be corrected so long as the global division of labor remains unchanged. And so long as the status quo brings gains to all parties, there is no impetus for change.

Second, the so-called "dollar hegemony"--or predominance of the dollar in international trade--is not the cause of imbalances, either. Even if the dollar did not dominate world trade and finance, there would be imbalances as long as countries stick with their comparative advantages. The "dollar hegemony" only attracts excessive liquidities to the United States.

Third, promoting the yuan as a settlement currency will not solve China's problem of external imbalances. Nor will moderate adjustments of the yuan's exchange rate against major currencies. A sharp revaluation may be required to reduce China's current account surplus to a reasonable level. Yet that would probably lead to large swings in the yuan's value, a result China would not like to see.

China will continue its export-led growth model over the next decade primarily because the long-term factors affecting its position in the international division of labor--especially its comparative advantage in manufacturing, reserve of labor in the countryside, and a low dependency ratio--will not change quickly.
Of course, one would need to see the underlying study (which I can't find online) before giving these findings too much weight, but it does make sense if you look at basic bilateral trade and currency stats over the few years.  Between mid-2005 and mid-2008, the RMB dropped about 15% against the Dollar, and yet Chinese imports into the US steadily and significantly increased over that period (as did US exports to China).  The overall bilateral deficit also increased.  If the USD-RMB exchange rate was really the nasty deficit driver that the protectionists claim it is, wouldn't you expect a noticeable decline (or at least a deceleration) of Chinese imports and the bilateral deficit over that period? Granted, I'm certainly no expert in this area, but these basic data sure seem to argue that something other than currency is dictating bilateral trade flows.

In less than two weeks, Treasury will publish its semi-annual report on China's currency.  Although it's quite unlikely that China will be labeled a "currency manipulator" in the report for both pragmatic and legal reasons (the law's hurdles are very high), Treasury's announcement is sure to cause myriad US politicians, union leaders and manufacturers to loudly call for dramatic US action against China to force a revaluation of the RMB versus the Dollar and thus to decrease the bilateral trade deficit.  The analysis of Ranson and Yao, as well as the basic trade data discussed above, strongly suggest that free traders should question not only the protectionists' dangerous means for bringing about a revaluation of the RMB but also the underlying - and widely accepted - argument that any such revaluation would dramatically affect US-China tradeflows.

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