China recently announced that it would allow greater flexibility in its currency. In a video Q&A, Yukon Huang, former country director for the World Bank in China, explains the significance of the timing, what a flexible currency will mean for China and the West, and whether the renminbi is likely to rise or fall.
While China was ready to introduce greater flexibility for some time, the political pressure from the West actually delayed movement as Beijing didn’t want to be seen as bending to outside demands. Huang says that the upcoming G20 meeting likely influenced the specific timing of the announcement, but the collapse of the euro offered a good opportunity for change. This signals Beijing’s emphasis on increasing domestic consumption and alleviating income disparity, but Huang cautions that it won’t necessarily be beneficial for the United States.
- What is the significance of China’s announcement that it will increase the flexibility of its exchange rate?
- Did Beijing bow to international pressure to appreciate its currency?
- Why has China been reluctant to abandon its peg to the dollar?
- Is the renminbi undervalued and will it rise against the dollar?
- How will the change influence China’s economy?
- Will a flexible exchange rate rebalance China’s trade with the United States and reduce trade tensions?
- Will this decrease U.S. pressure on China to further alter its currency policy?
What is the significance of China’s announcement that it will increase the flexibility of its exchange rate?
The change in China’s exchange rate policy, as announced over the weekend, essentially illustrated that China is now ready to move on the flexibility of the exchange rate. This is an issue that the whole world had been waiting for.
What the announcement indicated was that China believes that changing its policy is in its own interest. From a practical standpoint, it has been in China’s own interest for a long time now, but China had to wait for the right opportunity to do this.
In terms of how it was in its own interest, China’s stimulus program has succeeded, the risks of the financial crisis have more or less passed, and China could see that it wasn’t going to be negatively affected. Its exports are booming and its economy is growing very rapidly. China realized that not having a flexible exchange rate was essentially giving up a policy tool to manage its economy and therefore took the decision to move forward.
When China announced that it would make its exchange rate more flexible, the emphasis was truly on flexibility. It certainly didn’t signal and major change in terms of appreciation, but acknowledged that some appreciation was possible and likely to happen. China thought that the size of the potential appreciation was not the most significant factor. It also knows that it needs to remain broadly stable, so whatever happens it will be modest and take place over time.
Did Beijing bow to international pressure to appreciate its currency?
China was actually ready to introduce more flexibility in its exchange rate for a long time now—months probably. In some sense all the political pressure from the West and the United States to appreciate the currency probably delayed it because China, as most people recognize, does not want to be seen doing something based on pressures from outsiders. For its own domestic audience, China needed to say that it was taking action for its own sake.
In that sense, the announcement is in China’s interest and will allow China to decide whether to change its interest rates, whether to tighten its fiscal monetary policies, and whether to liberalize its capital flows more. Having a more flexible exchange rate allows China to actually strengthen its whole economic policy management.
There is debate over whether or not the upcoming G20 meeting influenced the timing of the announcement and whether the Chinese wanted to do it now so that President Hu Jintao would not face tremendous pressure from the other leaders to take action. This is a realistic interpretation of what actually happened. The government does not like going into these types of meetings with all of the focus on the exchange rate, so from China’s perspective getting this out of the way was highly desirable.
If the G20 meeting wasn’t happening, they might not have done it now, but the announcement wouldn’t have been much later.
In some sense they’re also dealing with the collapse of the euro. The collapse of the euro actually offered ideal timing for the Chinese because with the euro falling the dollar was appreciating and the renminbi was appreciating along with the dollar. So, there was something like a 15 percent appreciation over the last several months. This appreciation actually gives China a lot more flexibility as it doesn’t have to appreciate as much as it might have. It could actually adjust the exchange rate either way.
Given what’s been happening—the movement of the euro and increased volatility—the renminbi could move either way. It could move up, or it could move down. On Sunday, the renminbi appreciated by 0.4 percent. On Monday, it depreciated by 0.2 percent. While there was some surprise, this was expected as China essentially said that the currency could go either way. There are commentators who are talking about whether China wants to make it clear that the exchange rate flexibility is not a one-way bet and that it will not just appreciate. If Beijing is successful, over the course of the coming year the renminbi may move in a way that is not predetermined by market speculators, which China really needs to get away from.
Why has China been reluctant to abandon its peg to the dollar?
When there is a great deal instability, uncertainly, and a financial crisis, the Chinese basically hunker down and make sure that most things are under their control. The exchange rate is one key instrument. The best example of this was probably seen during the Asian financial crisis. Currencies around them collapsed and there was a lot of discussion about whether China should depreciate the renminbi at that time in line with the declines of the other regional currencies. But they held it constant. They also realized that by holding it constant it created an anchor for other countries and helped stimulate demand, maintain stability, and in some sense bring back Asia as a whole faster.
Now by the same reasoning, holding the renminbi constant for the last couple years has probably helped Asia recover from the financial crisis and move forward faster than it would have otherwise. All Asian countries have seen growth rebound quickly over the last six or seven months. Trade volumes have jumped and trade within Asia has ballooned. This possibly accounts for a quarter or a half of the entire growth in global GDP. With China as an anchor, the rebound in Asia is seen as very positive from an Asian perspective.
For China to maintain a truly flexible exchange rate, money needs to flow in and out in line with trade patterns and ordinary capitol flows and not be driven by speculation. There have been various studies over the last couple of years that have estimated that maybe 20–40 percent of the capitol flows going to China were largely driven by the assumption that the renminbi would appreciate. There was nothing to lose. After all, if the renminbi appreciated about six or seven percent a year and interest rates in Western economies are about three percent, there is a guaranteed two or three percent return. This encouraged more capital flows and more speculation. China needs to get into a situation where this one-way bet is no longer what’s driving the market.
Now, for this to happen many things will have to take place. Inflation will need to be a little higher in China. Housing prices are high, so the potential for speculation in the real estate market is probably moderating. China is likely realizing that, in the future, it will not have to export as much as it has in the past to generate jobs because labor shortages are now emerging. China is also realizing that the composition of its exports should change. China needs to move to higher value products and an appreciation of the exchange rate will help in that regard.
China also realizes that the location of its economic activity should perhaps relocate from the coast area into the poor interior. So some modest appreciation is helpful in that regard. With all of these factors, China believes that a little appreciation will be fine. The Chinese believe that the trade imbalance will work out on its own. If that is the case, capital movements will probably become more liberal and money will start flowing out of China. It wouldn’t be surprising if people start to say they don’t know whether the exchange rate is going to get stronger or weaker a couple of years down the line. In that sense the flexibility policy will work fully.
Is the renminbi undervalued and will it rise against the dollar?
If you talk to economists you get every single answer in the book. Some will say it is severely undervalued and must appreciate by 20–40 percent. Others run elaborate models and say the renminbi is fine. What this illustrates of course is that there is no real answer to whether the renminbi is under or overvalued.
Looking just at the trade data, China has generated significant trade surpluses, but these trade surpluses increased precisely during the time that the renminbi was appreciating—from about 2005 to 2008. The great irony is that when the renminbi was fixed to the dollar and was no longer appreciating, trade surpluses actually came down. So the assumption that appreciating the exchange rate will moderate trade surpluses is certainly not true given the last couple decades of evidence.
There are all sorts of forces at work that drive exports and imports, and one needs to look at the exchange rate and its relationships to exports and imports and capital flows in a longer-term cycle. What’s really happening is that after the Asian financial crisis Asia built up its foreign reserves, increased its savings, and learned that it needed a greater security blanket to cover potential vulnerabilities in the future. That period of time is about over—ten years of building up financial reserves and a safety blanket is enough. That’s why countries in Asia are talking about how it is now time to deal with inflation issues, increase consumption, and grow demand.
There is also recognition among Asian countries that they don’t need to grow as fast. What is not fully realized yet is that by relying fully on domestic demand for growth, there is an expectation that growth will be lower because domestic demand cannot generate growth in excess of five, six, or seven percent. But a trade-based growth strategy—an outward orientation strategy—can generate growth of 10 percent. The really tricky issue or the issue people haven’t fully comprehended yet is that Asia is moving to a period of slower growth. Asia is saying that this is acceptable and that they’ve reached a point in their own stage of development where this makes sense.
How will the change influence China’s economy?
The greater flexibility gives China another tool for its macroeconomic policies—interest rate, fiscal, and monetary policies. By keeping the renminbi fixed to the dollar, China essentially lost one tool it could use to guide the economy. But now that it has it back, it has more flexibility. China can better deal with inflation, better moderate investment, and better deal with potential asset bubbles—so overall it is another tool that is helping China.
Secondly, it is consistent with the reorientation in China’s own strategy. China is now beginning to say that it needs to increase consumption. A stronger renminbi means that imports are cheaper so people will consume more and import more.
China is also saying that it does not need to produce as many labor-intensive products and that it needs to move to higher value products. It is trying to provide incentives for businesses to do so. The Chinese are also saying that the location of activity should be more focused on the central portions of China, not just along the exporting coastal areas. This is in its own interest because inequality and income disparity are becoming a serious problem in China. And one way to deal with that is to focus on the consumption-oriented services sector that tends to be more in the central portions of China.
So the appreciation strategy is part of a general refocusing of what China wants to achieve and is consistent with their longer-term objectives.
Will a flexible exchange rate rebalance China’s trade with the United States and reduce trade tensions?
This is a political issue. It is a political issue when the renminbi doesn’t move at all, it creates the image that China is manipulating the exchange rate. There are many countries, however, with fixed exchange rates. The Hong Kong dollar has been pegged to the U.S. dollar forever, but no one ever accuses Hong Kong of manipulating the exchange rate. The euro essentially created a single exchange rate for European countries, and the big debate right now in Europe is whether this is creating problems between the Germanies of the world and the Greeces of the world.
A fixed exchange rate by itself is not the issue because the problem solves itself through price changes and inflation. So the exchange rate on its own is not a fundamental tool in altering trade flows.
What really alters trade flows between countries is the balance between saving and consumption rates. The big issue in China is whether the Chinese will consume more and save less, and the big question for the United States and the West is whether they will start to save more and consume less. If it happens on both sides than these imbalances will be moderated.
In light of this, the exchange rate is not going to make much of a difference in terms of these imbalances. It will shift the debate in a more constructive way to government policy, consumption policy, saving policies, and structural issues. These are the big issues that affect trade balances. The appreciation by itself won’t actually alter China’s trade balances. Although it may shift the pattern of trade somewhat within Asia. The export surpluses of China are really the export surpluses of Asia as a region. Asian trade is primarily in parts and components and final assembly is in China and when it is shipped off, it looks as if the whole balance is a China imbalance, but its actually not—its an Asian imbalance.
Will this decrease U.S. pressure on China to further alter its currency policy?
The American public is hoping that a Chinese appreciation of its exchange rate will lead to more employment, more jobs, and a stronger trade pattern in the United States but one needs to be very cautious.
Appreciation of the renminbi by itself probably won’t alter the U.S. trade position, and some would argue that the United States may come out worse in the process—the cost of its imports will be higher, the cost of U.S. final products will rise, consumption may be hurt in the process, and there may even be a small decline in real wages in the United States because prices will go up, but earnings will not go up as much. So, the outcomes that may come from this in terms of its impact on U.S. welfare are potentially more negative than positive.
However, what this outcome will do in terms of Asia is actually start shifting some of the labor intensive activities to the poorer countries in Asia. This will encourage China to move to more higher valued activities, which will probably lead to higher global prices. Therefore, global consumption in real terms will actually decline a little bit. There are pluses and minuses to this, which are not fully reflected in the debate.
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