China’s Currency Dilemma

Contributed by Ian Chan

The International Monetary Fund’s Managing Director Dominic Strauss-Kahn remarked on October 8^th that a currency war “is not a solution” to the world’s economic woes and committed the Fund to resolving trade imbalances. Mr. Strauss-Kahn’s remarks followed a bill passed by the United States House of Representatives expanded the President’s authority to impose tariffs on virtually all Chinese imports to the United States. China responded promptly with a stern statement and threatened to bring the issue up with the World Trade Organization. Less than three weeks from the mid-term elections, and given the gloomy domestic picture, it is not surprising that the House has tried to direct voters’ anger toward a foreign country. Nobel Laureate Paul Krugman has written extensively in the New York Times that the United States needs to act swiftly, harshly, and broadly in order to press the Chinese to revalue its currency. However, these populist and protectionist measures will not help the U.S. or global economy, and must be avoided at all costs.

First one should look at a brief history of the currency issue. China’s currency, known as the Renminbi, was once loosely pegged to a basket of currencies including the U.S. dollar and the Euro in the run-up to the financial crisis. When the financial tsunami hit, China promptly re-pegged its currency strictly to the Dollar and it has stayed at that level since then. Most economists reckon that if the Renminbi was traded at market value, as the Dollar is, the Renminbi would be 25-40% above its current rate. In conventional international economics, an undervalued domestic currency means that goods and services are much cheaper as exports whereas imports are much more expensive, because the purchasing power of each Renminbi would be less than it should be. By making goods and services from foreign countries more expensive, China was able to keep its export industry going strong throughout the crisis.

Some have attributed this artificial undervaluation to China’s huge trade surplus, but it is not the only contributing factor. High savings rates and a culture of thrift also contribute to low consumption.  Although allowing the Renminbi to appreciate will help lower savings rate, the effects will not make a real difference until the long run and China needs to make decisions that minimizes shocks to the global economy in the short run. There are a few serious harms to revaluation. First, a slow and steady revaluation will prompt foreign investors to pour funds into the country’s financial markets as investors anticipate ever-increasing Renminbi rates and start gambling with the currency. This flow of hot cash would cause runaway inflation, which in a country such as China where price levels are not as flexible and financial markets are underdeveloped, would cause a crisis that would reverberate all around the global economy. Moreover, whether or not the world likes it, China is reliant on its export industry to employ its massive workforce and drive growth. A quick revaluation would drive a lot of these export companies into bankruptcy and cause huge layoffs. The consequences of having large amounts of unemployed youth roaming the streets are too grave for any Western politician to imagine. Furthermore, provoking a global trade war now by introducing protectionist measure would cause a global slowdown right when the recovery is in its early stages. If countries close their borders and shut out money flows, the mightily feared double-dip recession will hit the industrialized world, and with most industrialized grappling with sovereign-debt crises, there will be less room for expansionary measures. Is it unfair that China artificially undervalues its currency? Yes. Would it be better for the world’s rebalancing if China appreciates the Renminbi? Yes. But is this the right moment to do it, and is the U.S. pursuing the right path by introducing protectionist measures? Absolutely not. Let’s hope cooler heads prevail in the Senate and in the Administration.