China Should Revalue the RMB

The yuan’s peg to the U.S. dollar should end for the sake of
China, not because of outside pressure

By PHILLIP SWAGEL

Setting aside the heated political debate, and looking just at economic considerations, there are strong indications that China would benefit from allowing the yuan to strengthen against the dollar. The incomes of Chinese families would be higher, while inflationary pressures and the threats to financial stability and strong growth trends would be lessened. Over time, China also would benefit by moving to a floating exchange rate and an open capital account in which Chinese investors could purchase productive assets anywhere in the world and foreigners could invest more easily in China than today. There are risks to be sure, but keeping the current peg involves mounting costs, both economic and political. From China’s perspective, the change in the exchange rate regime should be made not because of outside pressure, but because it would be good for China.

Indeed, there is a degree of irony in the calls from outsiders for China to allow an appreciation of the yuan. After all, it was only seven years ago during the Asian currency crisis that China’s exchange rate policy was seen as a responsible contribution to regional economic stability, with the dollar peg hailed as a bulwark against competitive devaluation.

The ongoing accumulation of dollar reserves by China suggests that the yuan would strengthen against the dollar were it not for the peg. At the current exchange rate, this means that China is paying too much for the U.S. Treasury bonds it buys to prevent an appreciation of the yuan, while U.S. consumers and businesses are getting a discount on everything they buy from China. This gives the irony to the outsiders’ desire for the change in that the immediate impact of an end to the peg would mainly benefit China, while causing some economic difficulties for the United States and other nations. For the rest of the world, an end to the peg might be a case of “be careful what you wish for.”

Some simple math suggested by Desmond Lachman, my colleague at the American Enterprise Institute, illustrates the price China pays. China is building exchange reserves at a rate of about $200 billion per year, or roughly 13 percent of Chinese gross domestic product. If the yuan is overvalued by 25 percent, as claimed by many economic analysts, this means that China is paying about $50 billion too much each year for U.S. Treasury bonds. In other words, maintaining the peg involves China overpaying the United States by an amount equal to more than 3 percent of total Chinese income. A sufficiently large revaluation would end this gift. A floating yuan would make sure it does not happen again, since the exchange rate would adjust with changes in demands for currencies rather than having reserves built up or drawn down. Indeed, China would need hardly any foreign currency reserves under floating exchange rates.

A stronger yuan would be associated with a higher standard of living in China. Chinese firms would receive a higher price (in yuan terms) for exports, while consumers and businesses in China would pay less for imports. This improvement in the terms of trade means that incomes in China would be higher and Chinese families would be able to buy more goods and services.

The end of the exchange rate peg would also remove several mounting threats to China’s economic stability. The first is the threat to the financial sector posed by rapid money creation and excess credit growth associated with official purchases of U.S. Treasury bonds and other dollar assets to support the peg. Poorly-made loans are thought to have blossomed in this environment of easy credit, putting parts of the Chinese financial system at risk of failure in the event of a slowdown in growth that affects enterprises’ ability to service their loans. At the same time, the artificially weak yuan that has boosted exports has helped give rise to an unbalanced Chinese economy overly dependent on exports rather than domestic consumption. As a result, Chinese growth is susceptible to reversals in foreign demand, which could come about either from natural swings in the business cycle or man-made calamities, such as the tariff under discussion in the U.S. Congress, or protectionist moves in Europe. Either way, the fragilities stemming from the exchange rate peg would magnify the impact of any global downdraft on China.

A stronger yuan would reduce these risks. Over time, resources would be redirected from the export sector to productive activities aimed at satisfying domestic demand. And without an artificially strong expansion of credit, banks would be forced to look harder at borrowers. A Chinese financial system that did a better job at matching domestic savings to the best possible investment uses could result in continued strong capital formation without having half of domestic incomes tied up in saving. Chinese families would get to enjoy their output rather than setting so much aside to build factories aimed at exports.

This change in the composition of the Chinese economy will take time, and in the interim there would be risks from an end to the exchange rate peg. Exporters will find life tougher without the artificial cost advantage over foreign competitors. The manufacturing sector could slow as a result until domestic consumption picks up. In turn, banks would come under pressure as loans go bad. Some banks have made great strides in boosting the quality of their lending portfolios, as illustrated by recent moves toward initial public offerings on the Hong Kong stock market. Many others, however, remain beset by bad loans. These financial institutions would face the risk of collapse. In the worst case scenario, households could turn cautious if they worry over the security of savings-just at the time that Chinese growth depends on them to start spending to make up for slower exports.

Fortunately, China has the ability to counter these potential adverse impacts by tapping into its foreign exchange reserves to support domestic demand. A stronger yuan would impart a huge capital loss on these reserves. But this is a bygone-it is a loss that would be taken no matter what. And even a 25-percent devaluation and corresponding loss in yuan terms would leave a vast trove of reserves to be spent propping up the economy. Household consumption could be supported by the provision of public guarantees to deposits made in good faith at failing banks, while public works projects could be expanded to backstop investment (though here it would be wise to avoid the Japanese example of outright waste in public spending).

At the same time, it is necessary to allow for some failures. Indeed, the experience with banking sector problems in the United States and Japan suggests that it is vital to avoid attempts to sustain failed banks. Such bailouts of banks in Japan, for example, led to a decade in which the financial sector did not provide adequate support for productive investments. In the United States, the adverse impacts on investment of the Savings and Loan Crisis of the 1980’s were left behind when the Resolution Trust Corp. began to sell off bad loans in earnest. China has made important progress in preparing its banking sector to withstand a revaluation and eventual switch to a floating exchange rate. It is now essential to prepare for the inevitable failures and to resolve them rather than throwing away good money after bad.

These risks make the hesitation to revalue the yuan quite understandable. After all, growth has been strong in China and a far-reaching change such as a new exchange rate regime involves uncertainty as to the positive impacts along with inevitable economic disruptions. And yet, now it is a good time to act, with China in a position of economic strength. Helpfully, growth in the United States remains solid, suggesting that Chinese exports would not falter too much from a revaluation. Acting now would remove growing imbalances in the Chinese economy that could lead to more severe future problems.

Finally, when the yuan eventually floats, Chinese policymakers would be able to use monetary policy tools such as interest rate cuts to lean further against any continued economic difficulties.

Looking into the future, a stronger and more flexible yuan would be good not just for China, but also for the world economy. Chinese imports would rise with domestic demand, supporting growth in other countries. For the United States, this would have the beneficial effect of allowing U.S. consumers to spend less and save more while maintaining strong income growth. Over time, the initial appreciation of the yuan might even be reversed as Chinese diversify their asset holdings and invest in other countries.

It would be unfortunate if outside pressures were to make it more difficult for China to revalue the exchange rate. A stronger yuan would be associated with a more robust Chinese economy, and ultimately with more balanced and sustainable growth in the world economy. This, more than any political considerations, is the reason for China to act.