Saturday, November 6, 2010

The Economist: China's "Real" Exchange Rate Ain't That Undervalued

Great stuff here by the folks at The Economist, but it woulda been even greater if they'd released the analysis before that embarrassing House currency vote (and the mid-term elections).  But oh well:
AMERICAN manufacturers complain that China undervalues its exchange rate. But which one? The nominal exchange rate is now 6.67 yuan to the dollar, having strengthened by almost 2% since September 5th (when Larry Summers, an adviser to President Barack Obama, flew to Beijing to complain about the currency in person) and by 24% since 2005.

But China’s real exchange rate with America has strengthened by almost 50% since 2005, according to calculations by The Economist (see chart). A real exchange rate takes account of price movements in each country. If prices rise faster in China than in America, China’s real exchange rate goes up, even if its nominal exchange rate stays the same. That’s because higher prices at home make China’s firms less competitive abroad, just as if their currency had gone up.
To calculate the real exchange rate, you need a gauge of prices in each country. Many economists use the consumer-price index (CPI). But the CPI contains lots of goods and services (such as housing rents) that cannot be traded across borders. Our measure of the real exchange rate, which we will regularly update, offers a more direct measure of competitiveness by looking instead at unit labour costs: the price of labour per widget. These costs go up when wages rise or productivity (widgets per worker) falls. In American manufacturing, unit labour costs have risen by less than 4% since the first quarter of 2005, according to the Bureau of Labour Statistics. In Chinese industry they have risen by 25% over that period, according to our sums....
The combination of a 24% rise in the yuan against the dollar and a 21% increase in Chinese unit labour costs, relative to America’s, explains the steep appreciation shown in the chart. The yuan may well still be undervalued but our index suggests American manufacturing should have less to fear from Chinese competition than it did five years ago. Until June 2009 appreciation was largely because of the stronger yuan. Since then it is largely because China’s unit labour costs have grown much faster than America’s. Employers in China’s coastal factories have suffered labour shortages and strikes. America’s factories have reported strong productivity gains as they have wrung more out of the workers that survived the recession (although those gains will be hard to repeat).
This is entirely consistent with that the Congressional Research Service recently said about the RMB: ""Even without adjustment to the nominal exchange rate, over time the real rate would adjust as inflation rates in the two countries diverged." Such inflation, as evidenced in the Economist's calculations of diverging US-China unit labor costs, is exactly what's happening now - thus, the resulting rise in the "real" CNY-USD exchange rate.

Behold, basic economics!

This is more proof that those upcoming high-level G-20 negotiations about China's currency practices may be somewhat misguided, and that US efforts to force China to appreciate the nominal exchange rate are totally unnecessary (yet still very antagonistic).

I have no doubt that Chuck Schumer and every other US politician who demagogued China all year will be issuing a correction any second now.



Anonymous said...

This is all fine and dandy. But to the extent that Chinese currency manipulation causes any distortion in trade that is non de minimis, why are avowed free traders such as yourself so against doing anything about it?

Scott said...

Hi Anon,

Look, I (and I assume most other free traders) would like nothing more than to see China's (and every other) currency reflect market realities, but that's not gonna happen anytime soon. So off the top of my head on this sunday, I see at least three reasons why I don't want American politicians "doing anything" about it:

1) As many economists have noted many times, china's "undervalued currency" probably helps the US economy more than it hurts because the Chinese citizens are essentially subsidizing our consumption and borrowing and because there's little direct competition between US and Chinese goods and services.
2) The "solutions" out there are based on imperfect data and political pressure, so they'd likely cause more distortion and disruption, not less. And, even if the data were perfect, do we really trust our politicians to craft optimal solutions that disregard political pressures (e.g. favoring unions or certain industries)? I sure don't.
3) As the Economist data shows (and as the CRS predicted), this "problem" is going to eventually solve itself. You can only cheat the market for so long. Of course, american pols simply can't appear to "do nothing," so they scream and yell (which is just awesome for international relations).

And bonus reason: I don't want politicians dictating other nations' fiscal policies, particularly when their motivations have little to do with reality and almost everything to do with politics and control.

There are lots of other good reasons, but I think that'll do for now.