Free Floating RMB

Economists speculate about the impact of a revalued yuan

By JOSEPH BOSCO

FOCUS OF ATTENTION: There has been a lot of speculation about the impact of a revalued yuan

Pressure on China to revalue the RMB from its fixed peg to the U.S. dollar has risen almost to the boiling point-publicly, at least. At the recent meeting of the Group of Seven (G7) leading industrialized countries, John Snow, the United States Treasury Secretary, made it clear that the Bush administration expected immediate action from Beijing, pronouncing that “China is ready now to adopt a more flexible exchange rate.”

The Financial Times on April 18 quoted an unnamed senior G7 official on the sidelines of the conclave as saying, “It’s not a question of threatening China but of recognizing that this is getting urgent.”

However, in an official joint communiqué, the finance ministers of the G7 nations demanded China to take “vigorous action…to address global imbalances.”

At about the same time, Alan Greenspan, Chairman of the Federal Reserve Board in the United States, told a congressional hearing that China’s exchange rate “is preventing growth…that will be most valuable for China in the decades ahead.” He also testified that it was very much in China’s “interest to move…sooner rather than later.” Confidently, the chairman added, “They will move, I am reasonably certain.”

On April 30, The New York Times reported that the number one problem facing the new U.S. trade representative, Rob Portman, was a U.S. Congress “in near revolt over China’s refusal to alter its currency exchange rates.”

And on May 2, Asian Development Bank President Haruhiko Kuroda called for revaluation of the yuan. That came just a few days after both the World Bank and the International Monetary Fund “recommended” China revalue the RMB and that it be done soon.

However, China’s Vice Finance Minister Li Yong said May 6 at the annual meeting of the Asian Development Bank (ADB) in Istanbul that China has no immediate plans to float the RMB and there is no set timetable for China to loosen the currency’s peg to the U.S. dollar. Li said that domestic needs and reforms in the financial sector would need to be resolved first.

There’s a lot of fuss, no doubt. And though some have urged for a revaluation, others debate the impact it would have on the global economy should it happen. Most agree that the RMB would appreciate in the short term, but the question is by how much. The issue is of particular interest to U.S. economists. While the Bush administration has pushed for a free-floating RMB, there is a potential downside for the United States, as China’s largest export market, if American consumers are forced to pay more for Chinese goods.

Dr. Phillip Swagel, President George W. Bush’s Chief of Staff at the White House Council of Economic Advisers, 2002-05, explained the status quo. “If the RMB is now undervalued by 27 percent, as is sometimes claimed by people in the United States and elsewhere, this means that U.S. consumers and businesses are getting a discount on goods imported from China, while China is paying too much for U.S. Treasury bonds,” he said.

So it leaves the question as to who would benefit if the RMB were allowed to float and just how quickly China would go about loosening its peg to the dollar. Many economists have cautioned that an abrupt decision to float the yuan could weaken Chinese banking and shake the world economy. Finance Minister Li said that China would take into account the impact of revaluation on regional and global economies before making any decisions.

While the debate rages as to who would be the winners and losers of RMB revaluation, many analysts still believe that some form of revaluation is on the way, and it could soon.

Rising Value

The debate on revaluation is not about if the RMB would appreciate. It’s about how much it would appreciate. Most U.S. economists believe that short-term appreciation against the U.S. dollar would fall somewhere between 15 and 35 percent.

“The large and continued accumulation of foreign reserves in China shows that the supply of foreign currencies exceeds the demand for them at the exchange rate of the RMB,” said Princeton University Economics Professor Gregory C. Chow. “When supply exceeds demand, the price of foreign currencies in terms of the RMB should go down, or the price of the RMB in terms of foreign currencies should go up.”

Chow estimates that an appreciation of at least 20 percent is likely since the price of internationally traded goods produced in China appears to be at least 20 percent lower than those of other countries. Randy DuRie, a financial analyst for Plimsoll Capital, LLC, a prominent currency trading firm, believes that China’s trade advantage is even greater, and revaluation would cause the RMB to appreciate by as much as 27 percent. “The 27 percent tariff being discussed in Congress shows the size of the advantage Chinese companies have with the yuan pegged to the dollar,” he said.

Economist James A. Dorn, Vice President for Academic Affairs at the Cato Institute, said the RMB would “appreciate by 15-20 percent against the dollar and less against a basket of currencies.”

A recent surprise event would seem to support the predictions of rapid appreciation, and that it might indeed be significantly fueled by “hot money” speculation. For reasons that are still not clear, on April 29, the People’s Bank of China allowed the RMB to float for some 20 minutes and it immediately strengthened from 8.2770 to the U.S. dollar to 8.2700, the largest fluctuation since the exchange rate was fixed a decade ago. The brief float occurred only hours after China Securities Journal hinted that Beijing might experiment with some form of RMB revaluation.

However, Dr. Swagel, now a resident scholar with the American Enterprise Institute, cautioned that while the “mini float” bounce appeared to support the consensus predicting appreciation it was “not the whole story.”

Dr. Swagel believes that with increasing freedoms for the Chinese to invest in foreign markets, the “flow” might easily go in “the other direction” in time. “It would be no surprise,” he said, “to find Chinese investing all over the world. This flow in the opposite direction would put pressure on the RMB to depreciate.” Therefore, Dr. Swagel believes that predicting a consistent path for a revalued yuan is dicey for now.

Winners and Losers

John M. Letiche, Professor Emeritus of International Economics at the University of California, Berkeley, said appreciation would be good for the U.S. economy, but more in the sense that harsh medicine can be good for the patient. “It would…apply greater pressure for the United States to reduce its own budget deficit, and to refrain from imposing restrictions against Chinese exports of textiles,” he said.

In fact, Dr. Letiche believes that “preventing an increase in global protectionism” is one of the most important factors in favor of RMB revaluation. He also pointed out that appreciation of the yuan would “generate appreciations in other southeast Asian countries that have been pursuing mercantilist, export-led growth policies,” further reducing “imbalances in the world trade structure.”

The Cato Institute’s Dr. Dorn agrees that “we should look beyond the short-run impact-because initially the bilateral U.S. trade deficit with the PRC could increase.”

Dr. Swagel believes that RMB appreciation would have a mixed effect on the U.S. economy. “Certain import-competing industries in the United States would likely be helped by an RMB appreciation,” Dr. Swagel said. “But this effect would be limited as imports into the United States would likely switch to other trading partners. U.S. consumers would find their toys made in Latin America rather than in China-but [still] not in the United States.”

Americans would continue “paying more for imported goods, and the Chinese would be paying less to buy U.S. Treasury bonds,” Dr. Swagel said. “These would both represent a gain for China and a loss for the United States.”

Dr. Edward Friedman, Hawkins Chair and Professor of Political Science, University of Wisconsin, believes that RMB revaluation would not have much impact on the American economy. However, Professor Friedman said there could be at least one positive effect of revaluation: “[It] might remove some credibility for China-bashers in American politics.”

Dr. Reynolds believes revaluation would be bad for the U.S. economy, and not just because its consumers would be forced to pay higher prices for Chinese goods. “U.S. producers would face less competitive pressure; competitive pressure is what drives economic progress,” Professor Reynolds explained. “The appropriate adjustment for the U.S. economy is domestic fiscal discipline, not accommodation by China to reckless U.S. fiscal policy.”

On the finer point of a free-floating RMB, Professor Letiche is definite: “This policy would be ill-advised. U.S. hedge funds would speculate, raising the RMB further.” Dr. Letiche believes that revaluation should be a process of incrementally “widening the band” from the fixed parameter of 0.3 percent on either side of 8.2770 to the dollar.

Dr. Reynolds believes that China should carefully manage revaluation. “China should energetically prepare to float the RMB, but for the moment, a wiser path might be to revalue upwards, peg again, announce that the peg is to a trade-weighted basket of currencies, not to the dollar; don’t announce the specific composition of the basket, in order to keep speculators off balance,” he said.

Dr. Dorn explained an important distinction in the winner-loser question. “Since China imports components from the United States and other countries,” he said, “an appreciation of the RMB would actually lower production costs for foreign-invested firms.”

Other than the no-win no-way U.S. consumer, Dr. Dorn believes, “It’s difficult to pick winners and losers in the globalized economy.”

Not so for Dr. Letiche. “The winners would be U.S. and west European exporters,” he said. “The losers would be American and European consumers of Chinese imports.”

Interestingly, Dr. Letiche believes the United States Treasury Department has behaved responsibly of late on the RMB revaluation issue. For example, he pointed to the recent G7 summit, during which most members wanted to declare China “a manipulator of its currency.”

“The United States did not press for such a declaration against China,” Professor Letiche said. And the joint communiqué did not include it.

Dr. Letiche offered a tantalizing insider tip, “I believe that discussions by U.S. treasury officials and their Chinese counterparts have produced an understanding that, in its own [fashion], China will appreciate the RMB by September 2005.”