What China’s Currency Shift Could Mean
China is expected to announce that it will allow the renminbi or yuan, to appreciate against the dollar in the coming days. The currency’s value would fluctuate day to day and any increase in value could be gradual and limited. Even so, the move would be good news for the Obama administration, because an undervalued renminbi keeps China’s exports cheap and makes American exports more costly by comparison.
Will a somewhat more flexible exchange rate benefit the American economy significantly? What kind of effect will it have on the changing Chinese economy and other Asian economies?
What’s Good for China
Eswar Prasad is a professor at Cornell University and a senior fellow at the Brookings Institution. He is a former head of the International Monetary Fund’s China Division.
A shift in China’s currency policy is not a panacea for imbalances in either the Chinese or U.S. economies, but it puts in place an important piece to a complex jigsaw puzzle.
A currency move could boost household consumption, making the Chinese economy more balanced and less dependent on exports.
The immediate benefit of a modest currency adjustment is that it will cool off some of the overheated rhetoric in China and the U.S., allowing the nations to focus on important economic and strategic issues rather than getting into petty trade disputes.
A modest appreciation of the renminbi will not by itself wipe out America’s trade deficit or China’s trade surplus. But if this move generates momentum towards a more flexible exchange rate, it could help achieve some important objectives. Chinese officials speak of banking reforms as a key priority and consider their huge trade surplus a structural problem having nothing to do with currency policy. There is, in fact, a deep connection between these issues.
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Banks still dominate China’s financial system. Chinese banks must learn to respond to price signals rather than government directives about how much to lend and to whom. The central bank needs tools to convey those signals by changing interest rates as needed to cool down or stimulate credit growth.
Without an independent interest rate policy to guide them, banks will remain handmaidens of local government bureaucrats who want to pump up growth at any cost. This also has the unfortunate effect of keeping bank lending going mainly to politically well-connected large state enterprises rather than dynamic small and medium-sized firms that are more effective at generating jobs. This tilts the economy even more towards dependence on investment and exports to sustain growth.
The government’s desire to maintain a stable exchange rate relative to the dollar means that China is effectively importing U.S. monetary policy, constraining short-term policies and hampering longer-term adjustment.
For instance, even though U.S. interest rates are likely to remain low as the economy here is still weak, China really ought to raise interest rates now to help cool off bank credit expansion, prick incipient asset price bubbles and reduce the risks of inflation.
A flexible exchange rate would allow China to run a monetary policy better suited to its own economic circumstances. This, in turn, would facilitate banking reforms and help to shift credit flows towards private sector firms — both in manufacturing and services — that can generate more jobs.
And a currency appreciation would increase the purchasing power of Chinese households as imports become cheaper. This would boost household consumption, making the Chinese economy more balanced and less dependent on exports or investment.
These changes will ultimately be good for China itself and the U.S., with China able to take in more imports from the U.S. and the rest of the world. A more balanced pattern of growth in China will also aid the global rebalancing effort by creating room for other emerging market economies to allow their currencies to appreciate without fear of losing competitiveness to China.
A Slow Motion Train Wreck
Desmond Lachman, a resident fellow at the American Enterprise Institute, is a former managing director of Salomon Smith Barney and a former International Monetary Fund economist.
One cannot but help get a feeling of déjà vu following Timothy Geithner’s current visit to Beijing to extract from the Chinese the minimal amount of exchange rate flexibility that will allow him to resist strong Congressional pressure to deem China a currency manipulator.
A modest currency appreciation is unlikely to reduce China’s huge payment surplus, and that’s a problem for the U.S.
Is this not what happened in July 2005 when China misled then-Treasury Secretary John Snow into believing that an initial move toward a more flexible Chinese exchange rate would be the start of better policy coordination between the two countries to address China’s very large bilateral payment surplus with the United States?
China’s modest currency appreciation between July 2005 and September 2008, which was unaccompanied by measures to promote Chinese domestic consumption, did nothing to slow China’s rapid export growth or to halt its ballooning trade surplus with the United States.
There is little reason to believe that the modest currency appreciation now being proposed by China will be any more successful in reducing China’s huge payment surplus. For the U.S., this has to be of greatest concern given the sluggish economy and the likelihood that unemployment will remain at close to 10 percent as midterm elections roll around in November.
Recently, Mr. Geithner judiciously delayed the issuance of the Treasury’s currency report scheduled for April 15 to allow cooler heads to prevail in Washington and Beijing on the currency issue. One has to hope both for China’s own sake as well as for the rest of the global economy that China takes advantage of this interval to move decisively both to a more acceptable management of its currency as well as toward meaningful structural reform to increase its very low level of domestic consumption. These policy changes would reverse what appears to be a dangerous and inexorable drift toward a protectionist backlash against China in both Europe and the United States.
But after five years of empty promises from China about understanding the need for a more flexible exchange rate system, one should not hold one’s breath.
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