Delicious: DC's Top (Reputable) Currency Hawk Dramatically Lowers Estimate of RMB Undervaluation

Over the last few years, the debate in the United States over China's currency practices has taken significant RMB undervaluation as a given and focused more on its effects and possible US responses. A few folks out there (like your humble correspondent) have questioned this fundamental assumption, but for the most part - especially in Congress - the idea that the RMB might not be as super-undervalued as everyone says is rarely, if ever, entertained.  A primary reason for this strongly-held assumption is the fact that the highly-reputable and (mostly) pro-free trade Peterson Institute for International Economics has loudly and repeatedly told Congress - and pretty much anyone else who'll listen - that their rigorous economic models clearly and unequivocally demonstrate that, despite some appreciation over the last few years, the RMB remains seriously undervalued.  Congress, the Obama administration and campaigning politicians like Mitt Romney, in turn, have repeatedly cited to PIIE's numbers to justify their calls for more aggressive US action against China's currency practices. So what's going to happen on the Hill, in the White House and on the campaign trail now that PIIE's top currency hawk has dramatically changed his tune on the RMB?

A ballooning surplus as China’s exports soared provided the smoking gun in the case against China’s undervalued currency. Economists reasoned that it was the undervalued yuan that was responsible for China’s massive surplus, and a substantial appreciation would be required to correct it.

Helping lead the analytic charge was William Cline, a senior fellow at the Peterson Institute in Washington D.C.

In 2008, working with fellow Peterson economist John Williamson, he estimated the yuan would have to appreciate by 18% in real effective terms, 31.5% against the dollar, to bring China’s current account surplus down to 3% of gross domestic product.

Now, though, a surplus that expanded to 10.1% of GDP in 2007, has shrunk to just 2.8% in 2011 – already below the 3% target.

That has prompted economists to return to their spreadsheets to try and work out whether the contraction is a temporary blip, or here to stay, and what that means for the yuan.

The International Monetary Fund is expected to ratchet down its medium term estimate of China’s current account surplus when it publishes its World Economic Outlook next week, down from above 7%.

Mr. Cline is getting ahead of the curve. “I am coming to the conclusion that the current account surplus is likely to be lower than in past projections,” he said, sharing his latest thinking with China Real Time....

“If the medium-term surplus reaches 4% to 5% of GDP and the international norm is a ceiling of 3%, then it requires 1% to 2% of GDP reduction in the current account” he said. ”Given the size of exports in the Chinese economy, a 1% real effective appreciation of the exchange rate reduces the current account surplus by 0.3% of GDP. So a real effective appreciation of about 3.5% to 7% would be required to reach the target.”

That is a pronounced reduction in Mr. Cline’s estimate of the extent of yuan undervaluation.

"Pronounced" is a serious understatement: only a few months ago, Cline and his PIIE colleague estimated that the RMB was undervalued by a whopping 24%.  Now, he's down to about 5%.  That's quite the shift in only a few months, and the reduction blows a giant hole into the longstanding argument the United States must pursue aggressive, unilateral action to compensate for China's dangerous currency practices.  (Sorry, Fred!)

Now, I don't cite to Cline's revisions to make some definitive case that the RMB isn't undervalued or that China's currency policies are all fine-and-dandy.  No, my point remains the same as is has been for the last several years: it is simply impossible to know the extent and effect of China's currency policies, so American politicians and pundits are mind-blowingly wrong to push harmful US trade policies (like tariffs or other nasty things) and to incite public fear and anger on the basis of PIIE's (or anyone else's) wild guess as to what the RMB's worth and what it's doing to the US and global economies.

And just think if we had followed these politicians into the protectionist abyss on the basis of these uncertain numbers.  (We got really close: China currency bills passed the House in 2010 and the Senate in 2011.)  We'd be smack-dab in the middle of a nice little US-China trade war over either a problem that fixed itself in only a few short years or what turned out to be a steaming pile of hokum.

There's a lesson here, although I unfortunately doubt that its target audience will listen.

Indeed, now that Cline (and some of his PIIE colleagues) have changed their tune on the RMB, how many DC politicians are going to stop complaining about China's currency?  And how many US labor unions and protection-craving businesses will stop demanding consumer-crushing tariffs on Chinese goods to counteract China's supposed currency "manipulation"?  (Two days before Cline revised his figures, the US Steel Industry demanded that the House pass the Senate's currency bill.  I'm sure their retraction's coming any minute now.)

No, no one's going to change his tune in this election season.  Instead, the charade will continue, as it has for the last several years.

But that doesn't mean we have to listen to them.