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China Should Speed Up the Yuan’s Rise
Far Eastern Economic Review July/August 2007
by Jonathan Anderson
From the vantage point of 1998, or even 2002, it would have been impossible to foresee the degree of global attention the lowly-valued Chinese yuan generates today. Over the past few years, U.S. taxpayers have paid millions of dollars to finance a seemingly endless series of hearings on the mainland exchange rate, while lawmakers have introduced bill after bill to promote the adjustment of a system most people only vaguely comprehend (and a currency most have never held in their hands). Pundits routinely talk about over- and undervaluation as if they were the simplest concepts in the world, although at a higher level this issue has confounded and divided a host of trained economists. Across the Pacific, Chinese policy makers have been tearing their hair out trying to decide what to do with their currency—and here as well, most senior leaders on the mainland have only a rudimentary understanding of the principles involved.
FRED HARPER
In this article I will contend two points. First, many of the common arguments for and against the revaluation of the yuan are misguided. And second, at the end of the day China would clearly be better off with a stronger currency—for its own sake, and not just as a means of preventing global pressure—and would do well to move faster than the present pace. I’ll get to the “real?case for revaluation shortly. But first, we need to address the most common myths about the Chinese exchange rate.
It’s Not About ‘Manipulation’?
Let’s recall how a fixed (or quasi-fixed, in China’s case) exchange-rate system works. China’s central bank, the People’s Bank of China, publishes a daily exchange-rate quote and stands ready to trade the yuan against foreign currency at or near that published rate. When there is an excess of dollars on the market, either because of a trade surplus or net capital inflows, the PBOC purchases those dollars by issuing new yuan; when dollars are in short supply, the PBOC sells its own dollar reserves to make up the difference, removing yuan liquidity from the market in the process.
Over the past few years, the rising trade surplus means that the People’s Bank has been a continual net buyer, accumulating nearly $30 billion a month in official foreign reserves for a cumulative total of $1.2 trillion as of March 2007. This fact has led to criticism that China consciously set the yuan peg at a level that makes exports hypercompetitive and thus automatically generate enormous trade surpluses. But this doesn’t necessarily follow. Under a fixed exchange-rate regime, central banks essentially commit to live with what the market delivers to their doorstep, and in a technical sense the recent flood of dollars is simply what the market has brought to China.
In fact, when looking at policy intent it helps to keep two points firmly in mind. First, when the government first initiated the peg in 1997 it wasn’t to keep the yuan from rising. Rather, it was to keep the currency from collapsing. The end of the Chinese bubble in 1995-96 left the economy with a huge burden of bad debts at home and abroad: Profits were disappearing and real growth had probably slowed to low single-digit levels. Against this backdrop, the onset of the Asian financial crisis convinced many investors that the yuan would be the next domino to fall, and short-term capital began to flow out of the economy at an unprecedented pace. The authorities?decision to institute a de facto peg against the dollar was explicitly billed as a commitment not to devalue the yuan. As late as 2003, when then Premier Zhu Rongji officially retired from government service, he considered holding the yuan peg to be one of his crowning achievements, and one of China’s biggest contributions to global stability.
Secondly, the Chinese government has been as embarrassed as anyone else by the skyrocketing mainland trade balance. As late as mid-2004 China was running a trade deficit, and there was no sense whatsoever that the yuan might be structurally undervalued. It wasn’t until early 2005 that the trade surplus began to careen upwards to unprecedented heights—a trend that caught not only the government but also most outside observers by surprise. Consider the authorities?position: At the beginning of this decade the yuan was trading around eight to the dollar and most economists were imploring them to keep the peg in order to avoid devaluation. Six years later, the exchange rate is still roughly eight to the dollar, but now foreign policy makers are screaming that the yuan is the most undervalued currency in the world.
This is hardly a case for manipulation. “Whiplash?is more the operative word, as China struggles to come to grips with the massive changes of the past few years.
Exports Won’t Slow
For those who closely follow the mainland economy, the last few years have provided another interesting spectacle. Remember that the yuan has been strengthening gradually against the dollar, by 2% in 2005, another 4% in 2006 and at a 6% year-on-year pace so far this year. At the same time, Chinese rural migrant wages, which were rising leisurely at 3% to 4% per year at the beginning of the decade, are now shooting up by 10% or even 15% annually as factories come to terms with a dwindling supply of young, single farm workers.
This double-edged sword of an appreciating currency and rising labor costs should have imposed palpable damage on China’s traditional export sectors: toys, clothing, furniture, appliances and electronics processing. However, according to industrial earnings and profit statistics, overall light manufacturing margins have been as steady as a rock, with no signs of pressure so far.
Why? Because exporters simply passed on the costs to overseas buyers. In a world where individual country figures rarely tally on pricing trends, one of the startling facts is that Chinese, Hong Kong, U.S., Japanese and European data all agree that mainland export prices have started to rise in the past three years. From 1995 to 2003, dollar prices in traditional manufacturing industries like clothing and toys were falling on the order of 3% to 4% per year. Since 2004, however, those same prices have been rising by 3% to 4% per year, a very visible turnaround from the previous picture. Exactly the same is true for it electronics. According to partner country data, Chinese electronics prices used to fall by 6% to 10% per year in dollar terms. Now they are barely falling at all—and mainland data actually show a sharp increase in prices since the beginning of the year.
Why haven’t Chinese exporters felt more pain? The answer is that they’re very big. Visitors to mainland factories often return with stories of small suppliers fighting for survival on razor-thin margins in an overly competitive environment. This may be true for individual companies, but on an aggregate level China now has an enormous market share: 70% to 80% of total U.S. imports of toys, footwear and other low-end products, nearly 40% of total apparel imports and 35% of it electronics. In this environment, it’s very easy to pass on domestic cost pressures.
Of course, rising wages and a rising currency will eventually bring about the end of traditional low-end manufacturing in China, as production migrates to cheaper markets like Vietnam, India and Indonesia. But it’s not happening very fast. In fact, one of the most surprising trends in Asia is that neighboring countries have taken advantage of the “breathing space?offered by China to raise their own prices as well.
So for the next few years, at least, don’t look for yuan revaluation to slow the mainland export juggernaut. As best I can tell, the main impact would simply be to raise prices for global consumers.
No Jobs Savings
This doesn’t mean that an appreciating currency wouldn’t help lower China’s trade surplus—it would, mostly through stimulating import purchases. However, I do find it more than a little ironic that the country protesting the loudest over the yuan peg has arguably the least to gain from its removal.
A few numbers here should help put the U.S.-China relationship in perspective. In the three-year span from the first half of 2004 to the first half of 2007, the monthly mainland trade surplus jumped by nearly $20 billion. How much of that shift came from net exports to the U.S.? The answer is around $6 billion, broadly in line with the overall U.S. share in Chinese exports. On a nominal dollar basis, the lion’s share of China’s net trade expansion has been borne by the rest of the world.
The next point to note is that much of that $6 billion monthly figure actually comes indirectly from China’s neighbors as well. The bilateral U.S. trade deficit with China has grown from essentially zero in 1990 to 2% of GDP this year, but, tellingly, the U.S. deficit with all of Asia actually expanded by less, or only 1.5% of GDP. The reason is that many of the goods showing up on U.S. shores with a “Made in China?label used to say “Made in Taiwan?or “Made in Korea.?Now, as processing and assembly functions have shifted to the mainland, the headline bilateral U.S. deficit has rather artificially shifted in favor of China as well. Once I account for this “intra-Asian?effect, it turns out that most of the real increase in the U.S. trade deficit comes from elsewhere, including the Organization of Petroleum Exporting Countries, Europe, Canada and Mexico.
Nor is there compelling evidence that Chinese producers are suddenly taking U.S. jobs. Much has been made of the fact that the manufacturing share of U.S. non-farm employment dropped from 16% in 1990 to 10% this year—but remember that the share had already dropped from 32% in 1950. As it turns out, the U.S. economy loses manufacturing jobs at a straight-line pace of 4% per decade, both before and after China’s arrival on the scene. Moreover, traditional low-end light industries where mainland penetration has increased the fastest were already decimated in the U.S. decades ago, accounting for only 1.7% of total employment as of 1990. All told, it would be unrealistic to expect even the most aggressive yuan strengthening to have any significant macro impact on the U.S. economy.
Another important fact is that China’s gradual approach to moving the currency is not exactly threatening stability at home in the mainland. Many analysts describe an economy where massive foreign-exchange inflows are flooding into domestic liquidity, overwhelming the central bank’s ability to carry out monetary sterilization operations and pushing both real growth and asset valuations into extreme bubble territory.
Against this backdrop, however, the real surprise is how calm everything looks in China. The People’s Bank has been steadily mopping up foreign-exchange inflows for years now without undue pressures on domestic interest rates, and excess liquidity ratios in the Chinese commercial banking system have never been lower than they are today.
The credit cycle is relatively well-behaved, nationwide property prices are rising at a moderate pace, and it now looks as though the frothy mainland stock market has finally cooled down. At this rate, I see no reason why China couldn’t live even with record-high external surpluses for another few years to come.
And keep in mind that as high as those China numbers seem, they’re still much higher in other parts of Asia. The mainland current account surplus is now pushing 9% of GDP, similar to the most recent outcome in Taiwan and Thailand and far lower than in Hong Kong, Malaysia and Singapore. Cumulative sterilization debt from all sources may be close to 15% of GDP, but that figure is over 30% GDP in Taiwan and close to 40% in Malaysia. Yet the same people who ask how long China can resist the “flood?tend to be very silent when the talk turns to these neighboring economies, which have been quietly living with extremely large inflows for a long time.
The Case for Revaluation
If all of the above is true, then why bother to move the currency? The answer is that the real case for revaluation lies elsewhere. Despite the arguments above, yuan adjustment would actually help resolve some of China’s most significant problems at home, and make life easier for its trading partners as well, essentially a “win-win?move for the mainland economy. It has nothing to do with exports, however, or Chinese market share in traditional manufacturing—but everything to do with import spending on heavy industrial products.
To understand the logic, it helps to take a close look at the sources of China’s external trade balance by category. If, at the beginning of this decade, you had told a trained international economist that the mainland was going to grow at such a rapid pace for the next seven years, and integrate itself even faster into the global economy along the way, he or she would probably have guessed that China’s trade patterns would evolve along the lines of the first chart, detailing expected trade balances. As a labor-rich and resource- and capital-scarce country, economic theory predicts that mainland producers would have maintained their advantage in low-end industries like toys and textiles, and taken advantage of new opportunities in labor-intensive electronics processing, but also become growing net importers of natural resources and heavy industrial goods. This chart is, in effect, where China “should?have gone.
Now turn to the second chart, which shows where China actually did go over the past seven years. On the net export side of the balance sheet things didn’t turn out so much differently than economists would have imagined. China maintained a steady, even rising surplus and quickly gained ground in the IT electronics industry as well. As expected, the mainland also became more heavily dependent on imported commodities and raw materials.
The problem, however, arises in heavy industrial sectors. As you can clearly see in the chart, China did not develop into a rising net importer of capital goods and industrial materials. Rather, over the past few years mainland producers have actually become net exporters of steel, aluminum, auto parts and other machinery categories, much to the consternation of overseas economists as well as the Chinese government itself. This essentially “explains?the skyrocketing trade surplus: Mainland superiority in traditional export sectors should have been offset by growing imports of heavy industrial goods—but wasn’t.
How did China pull off this unexpected feat? The answer is by accident, rather than by design. From 2000 to 2003 the mainland saw an enormous boom in property and housing construction and auto sales. As a result, industrial materials and machinery profits were booming, and local governments and state enterprises began to invest heavily in areas like smelting, refining and auto-production capacity.
And as often happens in China, boom turned to outright bubble: At its peak in 2003, total bank lending to real estate and construction was growing at 80% per year, fly-by-night property developers were cropping up everywhere, and the pace of construction activity and auto sales reached unsustainable levels. By early 2004 the authorities were ready to act and they cracked down hard on the construction side. Short-term real estate finance was stopped cold, small developers went out of business in droves, and construction activity slowed sharply.
However, the government was never able to staunch the flow in heavy industrial investment. As a result, productive capacity in areas like steel, aluminum, auto parts and machinery grew much faster than domestic demand for the next three years. Profits at home started to fall and China began to export its surplus abroad, which leads us to the situation in which we find ourselves today. The mainland has become a sizeable net exporter in certain heavy industrial categories, and China’s trade surplus is running at $20 billion per month or so, up from virtually zero only three years ago. Of course this situation should gradually reverse itself over time. We’re already seeing better supply discipline in some areas, with new investment growth in auto plants and ferrous metals refining slowing considerably; as this slowdown begins to feed into lower final capacity growth, net exports should abate and eventually fall as well.
The “dirty little secret,?however, is that it’s not happening very quickly. Not only is China’s trade surplus still rising, but heavy industrial profits and margins are actually recovering as well, as mainland producers learn how to compete in global markets. And this could well fuel a further round of new capacity creation in key sectors. So there’s no guarantee that the trade balance will turn around any time soon—and even if the surplus does peak, say, by the end of this year, China still faces a long, hard slog ahead, with many years of inordinately high FOREX reserve inflows, monetary sterilization, and of course significant tensions with global trade partners.
What’s more, the central government has already tried everything else to remedy the situation. For the past three years, Chinese officials have attempted to cancel new heavy industrial projects or shut down plants directly, but as long as companies can make money by taking market share from foreign suppliers or exporting to overseas markets, there is little Beijing can do (and local governments have virulently resisted every suggestion that “their?project be the one to take the fall for the national good). The government has added environmental levies and fees, and is now taking steps to remove export rebates and raise trade-related taxes. To date, however, all of this has been to little avail.
In fact, there is only one measure that can fundamentally reverse the situation and cull excess heavy industrial capacity growth. This measure would be to significantly revaluate the yuan exchange rate.
I argued above that a stronger currency would have little effect on mainland exporters, since they have demonstrated their ability to raise prices to the final consumer. But keep in mind that things look very different on the import side of the equation. To begin with, China does not have a high global export-market share in industrial machinery and materials. Indeed, the economy has just barely turned the corner to become a net exporter at all. Unlike low-end manufactures where China is a dominant force, every single heavy industrial product category has a multitude of overseas competitors. While mainland exports tend to rely on imported components, thus diluting the impact of revaluation in the final cost structure, goods like chemicals, metals and machinery have a much higher domestic value-added component. As a result, any increase in the value of the yuan has a much larger “bang for the buck?in these sectors, making imports immediately more competitive and shifting expenditure patterns much more rapidly.
Faster revaluation is now the only real adjustment tool available to the Chinese authorities. The glory of using the currency is that it helps reduce the trade balance, lowers the incentive for further excess industrial capacity creation, acts in a targeted way against the most energy-intensive and polluting sectors, and redirects spending towards higher imports from China’s Asian neighbors (alas, the U.S. would benefit less, as most of the initial “loss?in heavy industrial imports came at the expense of Japan, South Korea and Europe)—and all from a single policy decision.
So why doesn’t China go? To date, the government has resisted calls for a large one-off move as well as much faster appreciation on the grounds that such a move would be destabilizing. And I do have sympathy for this view if we talk about a revaluation strictly defined—i.e., a sudden, overnight move of 15% to 20% in the yuan exchange rate against the dollar. This could have a disastrous impact on exporters whose contract prices were set at the old exchange rate, especially with the relative lack of formal hedging mechanisms.
But these arguments don’t really hold for a faster trend appreciation. Other Asian economies regularly see much larger swings in their exchange rates without undue impact on growth. Consider that since the beginning of 2005 the yuan has moved by 8% against the U.S. dollar. By contrast, the Thai baht had a peak-to-trough swing of 23% against the dollar; the Indonesian Rupiah moved by 21%, the Philippine peso 19% and the Japanese yen 19%. In fact, the only currency that saw less trend volatility was the Hong Kong dollar; 8% over a two-period is laughably small by emerging- market standards.
So not only have Chinese exporters lived very comfortably with mild trend appreciation to date against the dollar, they’ve actually been gaining competitiveness against their neighbors whose currencies have been strengthening even faster. And to reiterate the point I made earlier, mainland producers are far more likely to pass costs along to consumers than any other Asian country. I don’t see any reason for strong caution here.
On another front, a few prominent economists argue that China is giving up its “monetary anchor?by letting the currency float—but as far as I can tell, the country never really had one in the first place. The exchange rate plays a significant price-setting role in small, open trading systems, but China is a very large, domestically driven economy with a much smaller traded sector than in other regional neighbors. A currency peg certainly didn’t prevent the mainland from careening between massive inflation and sharp deflation in the 1990s, and there’s no reason to expect that it would today.
A final, more nuanced argument concerns speculative pressure, i.e., the view that China can’t move too fast or else investors will start to see a “one-way bet? and flood the country with capital inflows. This is a valid point in theory, but in practice I’ve never seen evidence that single-digit rates of yuan have led to any sizeable capital movements. In fact, the main driver of “hot?portfolio flows to date has been asset- market returns.
Expectations of a looming revaluation helped pull money into the country during 2003-05, but the real draw was the Shanghai property market, where the price of luxury flats was going up by 70% to 80% a year. By contrast, hot money flowed out of China in late 2005 and 2006, despite the fact that the yuan was strengthening at an 8% year-on-year rate late last year. It wasn’t until the domestic stock market really began to boom, with 10% to 20% monthly returns, that we finally saw portfolio flows coming in again over the past six months.
Given the real transaction costs involved in evading capital controls and moving money in and out of the country, the authorities have little to fear from letting the yuan move at a 10% year-on-year pace in the near term. Will it happen? As of this writing, China is not quite there yet—but I believe the benefits of faster currency adjustment will gradually and steadily make themselves apparent. Watch this space.
Mr. Anderson is chief Asian economist at UBS.
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[此贴子已经被作者于2007-9-9 6:02:33编辑过]
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