Some Thoughts on the Undervalued Yuan

Tensions between the US and Chinese governments flared up this week regarding the negative effect of the undervalued yuan on US exports.  I don't think claims that the yuan is not undervalued hold much water -- China maintains a fixed exchange rate to the dollar, accumulates dollar-denominated assets, and runs a large trade surplus with the US.  How exactly does that suggest that the yuan is anything but undervalued relative to what it would be if it floated? What to do about is more subtle.

Paul Krugman is correct when he calls this a drastic form of mercantilism, and he has a point when he argues for a tough stance against the low value of the yuan:

Look, I know that many economists have a visceral dislike for this kind of confrontational policy. But you have to bear in mind that the really outlandish actor here is China: never before in history has a nation followed this drastic a mercantilist policy. And for those who counsel patience, arguing that China can eventually be brought around: the acute damage from China’s currency policy is happening now, while the world is still in a liquidity trap. Getting China to rethink that policy years from now, when (one can hope) advanced economies have returned to more or less full employment, is worth very little.

These mercantilist games have historically been played by sovereigns who think only of their own imperial glory -- how much gold they have in the palace -- rather than the welfare of their citizens.  The citizens are forced to work, to export, and to send the foreign exchange not to their own consumption but to their sovereign's coffers.  Obviously, China's leaders have something in mind besides improving the near-term consumption levels of Chinese citizens.  Their concern is continued employment growth.. There are over 100 million migrant workers seeking employment. China needs to continue to transition workers out of legacy state-owned enterprises and into a stable private sector.  I don't think it is anything insidious toward the US -- it is just the same sort of export-led growth that we have seen from many Asian countries, but now on a much larger scale.

As a policy matter, the US has an interest in that transition working out well.  The question is how much we have to give up to help them out.  We have not managed our end of the relationship wisely -- we have used the fact that China had a strong desire for US Treasuries and a willingness to overpay for them to go on a consumption binge and a housing binge, both of which were unsustainable.  So we need to unwind a bit from our previous positions.  As Michael Pettis discusses very clearly, though, we don't have to unravel:

So Americans over-consumed and Chinese over-saved. The system worked well for quite a while, until, as happened with the Japanese case in the late 1980s, US debt levels and unemployment rose to economically and politically unacceptable levels.

For China and the US to adjust means both of them unwinding this trade-off. Beijing will have to enact policies that reduce the subsidies to manufacturers and return the income to Chinese households. But this automatically means depressing economic growth and, more importantly, depressing employment growth.

This shouldn’t be a serious problem if it happens slowly. As Chinese manufactures gradually lose their subsidies, they will rely more than ever on the consequent rising Chinese consumption, and so domestic consumption will replace subsidized foreign demand as the source of growth. Not only will China have a safer and more balanced economy, but it will be more innovative (consumption tends to drive innovation, not production) and much more efficient.

But China cannot adjust too quickly. If Beijing removes the implicit subsidies, including those caused by the undervalued exchange rate, too rapidly, that could force large-scale bankruptcies as Chinese manufacturers found themselves unable to compete globally or at home. If these bankruptcies forced up unemployment, then paradoxically even as the transfers from households to businesses are being reversed, household income would nonetheless decline as unemployment soared. In that case Chinese manufacturers would find themselves becoming uncompetitive in international markets just as domestic markets are collapsing.

The conclusion? A rebalancing is necessary for China, as nearly everyone in the leadership knows. This will involve, among other things, a significant revaluing of the currency. But rebalancing cannot happen too quickly without risking throwing the economy into a tailspin.  That cannot and should not be a part of the US or Chinese policy objective.  By the way if China is forced to revalue the currency too quickly, it will have to enact countervailing policies — lower interest rates, suppress wages, increase credit and subsidies — to protect the economy from falling apart, and these will exacerbate other imbalances that may be even worse than the currency misalignment.  Currency revaluation, then, should be part of a broader adjustment process.

There is no need to solve this problem overnight.  But there is a need to lay the foundation for solving it as soon as possible.  It ought to be done diplomatically.