Sunday, December 14, 2008

China 2008: Revaluating the Currency Question

The U.S. trade deficit with China hit a record $256.2 billion in 2007. This includes U.S. imports of more than $30 billion worth of clothing and other textile goods. China, on the other hand, has surpassed Japan to become the largest holder of foreign currency reserves approaching $2 trillion, a large percentage of which is held in dollar-denominated Treasury notes. For the last three years, China has allowed a crawling 20% appreciation of the yuan against the dollar. But in the last week, and for the first time since the yuan was pegged to the dollar over a decade ago, China’s central bank allowed the yuan to depreciate against the dollar in its sharpest decline since 2005.

Ostensibly, Chinese officials allowed the yuan to drop not to increase the competitiveness of flagging exports, but to compensate for a rapidly rising dollar. The move, however, was also seen as chiding President-Elect Barack Obama’s recent hard line against China’s alleged currency manipulation. Regardless, the resumption of yuan depreciation against the dollar promises broader implications for U.S.-China relations and global economic health. This post tracks the story behind the persisting currency issue between the U.S. and China.

Under pressure from the U.S., China began a gradual revaluation of its currency, the yuan, against the dollar in July 2005. Over the course of the last two years, mounting concerns have been raised over the U.S.’s growing trade deficit with China. U.S. politicians widely saw the revaluation of the yuan as the primary means by which trade rebalancing would occur. A stronger yuan, they argued, would mean less dumping of Chinese goods into U.S. markets and would also increase the competitiveness of U.S. exports to China. China has as of late countered currency misalignment criticisms by pointing to the U.S.’s own financial excesses that have led to the current crisis. China has also suggested that the U.S. increase its savings rate to mitigate its deficits.

Much of the U.S.’s leveraged economic boom in the last half decade, however, comes from debt essentially underwritten by China. U.S. pressure upon China began roughly in tandem with China’s skyrocketing foreign currency reserves. Amid growing consensus that China’s undervalued currency and cheap labor gave it unfair advantage in international trade, Congress passed a resolution in 2004 specifically crafted towards mitigating the U.S.-China trade imbalance. The resolution declared that if China failed to revalue its currency within six months, a 27.5% tariff would be imposed upon all U.S.-bound Chinese exports. A year after the resolution was passed, China unpegged its currency from the dollar and allowed it to float within a range determined in a relation to a basket of currencies. The yuan has gradually trended upward in value against the dollar since the July 2005 policy shift. Then, in early 2006, several U.S. senators made good on their promise and drafted a bill that would impose the protectionist tariff on Chinese imports if China did not “substantially” revalue its currency exceeding the then current rate of 5%. According to Senator Schumer, the bill was intended as a prod to the Chinese government to reconsider its currency policy. U.S. legislative action was followed by a bridge-mending trip to China in which Senators Charles Schumer and Lindsey Graham discussed, to no resolution, their concerns with Chinese officials.

On the U.S. side, the debate over the currency issue falls between two camps: those who see China’s trade surplus as a threat to U.S. interests and those who see the surplus as symptomatic of larger international trade issues. The former group, many of which are politicians, support faster yuan revaluation. The latter group serves as a sophisticated rebuttal to the former, but is not discussed at length in this post. Suffice it to say that this latter group argues that yuan revaluation is not the answer and points to structural reforms in the Chinese economy with improvements in taxation, the corporate and banking sectors, and capital accounts as ultimately where change needs to happen most. Both groups insist, however, that China must increase domestic consumption and decrease dependence on exports.

Why are China’s foreign currency reserves a threat to the U.S.? Large foreign currency reserves give countries the ability to regulate the value of their own currency. For example, selling yuan for dollars allows China to depreciate the yuan, as more yuan on the market make it cheaper. China’s central bank, however, has not pursued a devaluation of the yuan for some time, however. Dollar-denominated securities are attractive to buy because there is a highly liquid market for them. Depreciating the dollar has several consequences, but prominent among them is the double impact on the current account deficit: imports decrease (because goods are more expensive for Americans) and exports increase (because American goods are cheaper for foreigners). Alternatively to dollar depreciation, an increase in U.S. saving has a similar effect on the current account, as such action would amount to reductions in investment or consumption, or both. Furthermore, this increase in savings is precisely what both U.S. policy makers and Chinese officials have urged.

In 2008, several notable currency-related events took place, culminating in the yuan’s intentional December depreciation. On June 10, 2008, Treasury secretary Henry Paulson called for continued “robust engagement” with China over the currency issue. A week later saw a record yuan valuation at 6.8918 per dollar, a 20% increase since being unpegged from the dollar. In August, just prior to the beginning of the Olympics, the yuan declined against the dollar six time in the course of nine days. The weakening yuan indicated what some Chinese observers interpreted as the central bank’s policy shift toward slower appreciation of the yuan to address domestic inflation. Finally, in the wake of the Olympics, the record trade surplus reported in November was less an indication of strong exports than it was of a comparatively faster decline in import growth.

In a recent lecture on U.S.-China relations hosted by U.C. Berkeley, The Atlantic Monthly’s National Correspondent James Fallows concluded that, in terms of the U.S.’s policy towards China, we need “more of the same.” Fallows said that despite the slew of foreign policy failures of the last eight years, the Bush Administration has maintained a good relationship with China. But foreshadowing policies that may not augur well for that relationship’s future, Obama addressed a letter to the U.S. textile industry just days before the election in which he accused China of currency manipulation. In July 2007, Obama had pledged to support the levies on Chinese imports. While the Bush Administration has been, to some success, negotiating with Beijing over currency revaluation, it has refused to formally label China a currency manipulator, as it does not want to incur intervention from the World Trade Organization. China’s foreign ministry spokeswoman Jiang Yu responded that the yuan exchange rate is not the cause of the trade deficit and that increased exports to China and reduced barriers to trade and investment would ameliorate the deficit. McCain, on the other hand, did not respond to the textile industry’s questionnaire. In rare statements of their China stances published exclusively on the American Chamber of Commerce website, however, McCain’s treatment of the currency issue was less pointed than that of Obama.

Following the release of the presidential candidates’ aforementioned statements on China, the I.M.F. reported in its October World Economic Outlook issue that China’s currency was “substantially undervalued.” A more flexible currency, it was reported, would contribute to the economy’s shift away from export-led growth to domestic consumption. China had previously tried to block publication of the report.

The question remains whether China will use its “nuclear option” and dump its dollars for other, stronger currencies like the euro. Several factors indicate, however, that China—and the rest of the world, for that matter—shouldn’t discount the dollar just yet.

In recent months, the dollar has rebounded from a six-year decline against the euro. Despite low interest rates, little prospect of U.S. economic growth in the near future, immense deficit financing, and, for now, cheap oil (which is priced in dollars and thus arguably inversely proportional to them in value), the dollar seems resilient amidst the financial crisis. Although China has long expressed interest in diversifying its foreign currency reserves portfolio, we can expect no dramatic jettison of dollars. The two heavyweight economies are too intertwined for such measures, and the safe haven of Treasury notes has, thus far, continued to provide currency traders respite from the storm. Indeed, there has been little indication that U.S. bonds, in general, will not continue to find eager buyers. Pressed with the opposite hypothetical situation in 2007, both Fed Chairman Ben Bernanke and Treasury secretary Henry Paulson have dismissed the possibility of dollar divestment en masse.

Whether China’s recent devaluation of its currency marks the beginning of trade strains between the U.S. and China is uncertain. Yet the potential global impact of such devaluation is worth considering. Hans Redeker, currency head at BNP Paribas, said that a policy shift could result in widely-felt repercussions: “If they play this beggar-thy-neighbour game, it will cause a deflationary shock for the whole world.”

At the Strategic Economic Dialogue in Beijing earlier this month, Paulson responded to Chinese concern over rising job losses in China’s export manufacturing sector in saying that the losses were due to slowing global demand, not the dollar’s appreciation. In response to a question about China’s dollar-denominated public debt holdings, a Chinese representative reiterated his concern over the “protection of [Chinese investors’] interests.” Concerns from both parties, whether we like it or not, must be mutual.