Reprinted from The Asian Wall Street Journal © 2004 Dow Jones & Company, Inc. All rights reserved.
(See Corrections & Amplifications item below.)
U.S. President George W. Bush's call last week for the Chinese leadership to revalue the yuan is likely to keep alive various misguided arguments for a revaluation or for an immediate increase in exchange-rate flexibility, which many interpret as synonymous with revaluation.
Politics and lobbying are responsible for these misguided emphases. President Bush's Republican platform states that China manipulates its currency for unfair trade advantage -- directly contradicting the findings of the U.S. Treasury and Congress's own Government Accountability Office, which just gave its stamp of approval to Treasury's methodology for investigating manipulation. Sen. John Kerry also derides what he calls China's "illegal currency manipulation." In an election year, no one dares defend China, it seems.
But reviewing China's currency situation confirms that neither China's currency nor its determining mechanism needs immediate change. Reform of China's exchange-rate regime is indeed a medium-term concern, but in the interim our exchange-rate focus should be on the necessary preparations.
Instead of exchange rates, our attention should move on to the more momentous trend symbolized by China's first-time participation -- albeit only partial -- in recent G7 meetings. China's economy has quickly gained international stature, and its domestic economic decisions increasingly have international consequences.
Yet China's economic decision-making process is poorly understood abroad, and its high-level leaders rarely if ever go to working meetings with their foreign counterparts. Indeed, China's top economic official Zeng Peiyan, who supervises coordination of fiscal and monetary policy and chairs China's interagency committee on the exchange rate, was not even in Washington for the G7 meetings. Instead of working toward his future attendance, however, the meetings again raised exchange rates. In doing so, they sustained distortions and confusions that risk misleading policy makers well into the future.
The arguments against China's current exchange system take four basic forms.
The first asserts that China unfairly makes its currency cheap, thereby cheapening its exports as well. So-called evidence points to China's huge and growing trade surplus with America and its huge and growing foreign-exchange reserves.
These crude arguments have problems. A country's trade with just one of its partners tells us little. While China has a surplus with America, its deficit with the rest of the world is so large that its overall global trade surplus in goods and services is a mere 2% of GDP -- hardly evidence of an unfair advantage.
Similarly, China's build-up of foreign-exchange reserves results not from trade surpluses but from capital inflows, many of which are speculative and reflect an effort both to cause currency revaluation and then cash out on it.
The second criticism asserts that China's exchange rate needs to adjust until all foreign payments come into balance -- trade, capital flows and transfers. But overall balance is not a meaningful standard for evaluating an exchange rate. Capital flows are the thousand-pound gorilla in today's balance-of-payments playpen. They move around with such speed and power that mere exchange rates hardly tell them what to do. For China, net capital inflows largely reflect capital restrictions on outflows, not the exchange rate.
The third variety of criticism calls for a more flexible Chinese currency -- maybe allowing it to fluctuate within a wider band, for example, or pegging it to a basket of currencies. This is a different matter altogether, and calling for more flexibility results in misunderstandings of the issue. Parties concerned about trade confuse flexibility with floating and revaluation, since a floating Chinese currency with continued capital controls would grow stronger. Meanwhile, serious economists deny that flexibility necessarily means revaluation, and point to requirements for eventual capital-account opening. A call for flexibility thus seems to provide pressure for revaluation without actually doing so, and the debate is mired in confusion.
When China eventually makes significant changes in its controls on capital flows, it will indeed need a more flexible exchange rate to avoid crises and maintain the independence of its domestic monetary policy. But this has nothing directly to do with trade and trade balances, and allowing significantly greater flexibility before China's domestic financial regulatory bodies are stronger would be unwise. Besides, even if China were to announce tomorrow a wider band for currency trading, central-bank intervention would still determine where the exchange rate went, if anywhere, just as it does today.
The fourth argument calls for Chinese currency revaluation so that other Asian currencies can revalue -- a step considered necessary to correct U.S. trade imbalances.
But the proper way to account for U.S. imbalances is to ask which countries and regions have large global surpluses. The answer is the eurozone first, oil exporters second, East Asia outside Japan and China third, and then, fourth, Japan. China plays a minor role. So if China's currency needs no urgent correction, why not focus on those other economies directly? Perhaps because they are friends and allies of the U.S., and China is an easier target.
It is time to stop scapegoating China's exchange rate and move on.
Mr. Keidel is senior associate in the China program at the Carnegie Endowment for International Peace. Until August, he was deputy director of the Office of East Asian Nations in the U.S. Treasury Department.
Corrections & Amplifications:
Due to an editing error, this article said in the first sentence that President Bush had called for revaluation of the yuan. The president only called on China to be more flexible in its exchange policy. We regret the error.