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The US dollar versus the Chinese yuan

C. P. Chandrasekhar
Jayati Ghosh

China is under increasing pressure from the US to revalue the yuan. With the US Government unwilling or unable to halt the decline of the dollar, this is seen as the means to prevent a dollar crash that can take the world economy into recession. In this edition of Macroscan, C. P. Chandrasekhar and Jayati Ghosh examine the background to this perception and its validity.

THE dollar is on the decline, with its value having fallen by around 30 per cent relative to other major currencies since 2002 and by close to 20 per cent in trade-weighted terms.

Yet, the US Government feigns being unconcerned with the problem. In the G-20 meeting held in the second half of November, the US Treasury Secretary reportedly refused to talk about the dollar's decline, though he reiterated the Bush administration's public commitment to halve the US government's budget deficit during its second term and bring it below 2 per cent of GDP.

The relevance of the budget deficit for the problem at hand is obvious, given the connection between the dollar's decline and the twin deficits in the US — the balance of payments deficit amounting to 5.5 per cent of GDP and the fiscal deficit to 4.2 per cent of GDP. With savings rates close to zero on average, private spending is high in the US.

But a large part of the demand this generates spills over into the international market given the lack of competitiveness of US producers.

However, this has not resulted in a domestic recession because the Government has in recent years been pump-priming the economy with deficit spending (though a part of that too leaks out abroad). In the event, the US has required the two deficits to sustain its reasonable rate of growth by developed country standards.

These deficits have not proved a problem because of capital inflows, including in the form of investment of surpluses accumulated by foreign governments and central banks in dollar denominated financial assets.

According to one source, in 2002, 2003 and the first half of 2004, foreign governments financed $564 billion (43 per cent) of a cumulative current account deficit of $1,318 billion (695 billion).

The problem recently has been that both private wealth-holders and foreign governments have begun to fear that the unsustainable value of the dollar spells a decline in the currency that could sharply erode the value of their assets.

The resulting rearrangement of their portfolio away from dollar assets in favour of other currencies is what explains the dollar's decline.

At one level this decline appears to be a boon to the US. It cheapens the foreign exchange value of its exports and renders imports more expensive in dollar terms, improving US competitiveness.

If this helps reduce the trade deficit, the size of the fiscal deficit needed to keep growth going would be lower. A process of self-correction seems to be providing a solution to the twin deficit problem.

The difficulty, however, is that the dollar's decline would also result in lower inflows into and larger outflows from US capital markets, resulting in a fall in financial asset prices that would reduce the wealth position of US households and institutions. This would reduce consumer spending and curtail demand. That problem could be aggravated by a possible liquidity crunch in the system, as banks and financial institutions experiencing a depreciation of their asset values turn cautious.

Further, lower financial asset prices imply higher interest rates that could affect investment adversely as well.

Thus a correction of the twin deficit problem through a depreciation of the dollar could also imply a recession in the US.

All this makes the dollar's decline a problem for the rest of the world as well, especially countries in Europe and in Asia, such as China, that are heavily dependent on the US market.

Dollar depreciation increases the dollar value of their exports to the US and undermines their competitiveness, and recessionary trends in the US would squeeze an important market for their exports.

It is this global effect of the dollar's decline that the US exploits to make the decline everybody's problem and not just its own.

In its view, the twin deficit problem can be best resolved through increased net exports (exports net of imports) from the US.

This would reduce the trade deficit, contribute to demand for US goods and help reduce the fiscal deficit without affecting growth adversely. So, Europe, Japan and China must help raise net exports from the US.

The G-20 meeting in November saw the Europe and Japan partly going along with the US on this count. "The Group of 20 leading rich and emerging market nations have agreed on a co-ordinated effort to reduce global trade imbalances by cutting the US fiscal deficit, reforms to boost growth in Europe and Japan and increasing exchange rate flexibility in Asia," reported the Financial Times on November 22.

That is, the reduction of the US fiscal deficit was made contingent on reflation in Europe and Japan which, hopefully, would expand the market for US goods, and reduced currency intervention by Asian governments aimed at pegging their currencies to the dollar. The latter, by resulting in an appreciation of Asian currencies vis--vis the dollar, is expected to increase the competitiveness of US exports to these countries and, therefore, in an increase in the volume of US exports.

The country which would be most effected by the second of these recommendations is China, which has pegged the value of its currency the renminbi (yuan) at 8.27 to a dollar since 1997. China has been under pressure for quite some time to revalue its currency and redress the "imbalance" that its trade surplus ($124 billion last year) with the US (Chart 1) and its large foreign exchange reserves ($514.5 billion) ostensibly reflect. That pressure has now increased, since Europe and Japan would like to see China bearing a larger share of the burden of global adjustment, by curtailing its exports and increasing its imports with a flexible and appreciating currency.

China's fears on this count are not just related to its trading position. It is more worried about the effects of introducing a more flexible currency and allowing the yuan to appreciate on its currency and financial markets. A stronger yuan is bound to spur large capital inflows, while capital account restrictions do not permit money to flow out easily. This would increase reserves further and drive the yuan even higher.

And once that happens, speculation on the value of the yuan can increase capital inflows even more. Such a spiral can be destabilising and weaken autonomy in monetary policy.

Not surprisingly, China is not happy. In an interview with the Financial Times, Li Ruogu, the deputy governor of the People's Bank of China, warned the US not to blame other countries for its economic difficulties.

"China's custom is that we never blame others for our own problem," he reportedly said. "For the past 26 years, we never put pressure or problems on to the world. The US has the reverse attitude, whenever they have a problem, they blame others."

There were three unexceptional arguments that Li used to justify his criticism. First, "The savings rate in China is more than 40 per cent. In the US it is less than 2 per cent. So the problem is that they spend too much and save too little."

Second, there was a lack of correspondence between US wages and productivity resulting from the tendency of the government to protect low productivity jobs. US workers enjoyed relatively high wages but remained excessively engaged in low value-added industries such as textiles and agriculture.

Finally, US policies discriminate against exports of goods that China needs. Restrictions on exports of military and high-technology products to China partly explains Beijing's huge trade surplus with America, he argues.

In fact, the evidence on China's trade does not support the view that it adopts a mercantilist policy that pushes exports and restricts imports. In 2003, while exports of goods and services amounted to 33 per cent of GDP, imports of goods and services stood at 32 per cent of GDP (Chart 2).

At present, China records an overall trade deficit, which is expected to touch $40 billion in 2004. In the first four months of 2004, China's exports amounted to $162.7 billion, up 33.5 per cent from a year ago. Imports, on the other hand, rose 42.4 per cent to $173.5 billion, resulting in an overall trade deficit of $10.8 billion.

A negative trade balance is sure proof that mercantilism does not drive trade and economic policy.

The reason why China is susceptible to international pressure despite this trade record is the country-wise distribution of its exports and imports. In 2003, merchandise imports from China into the US amounted to $163.2 billion, or 12.5 per cent of its total merchandise imports. This figure had risen from 6.3 per cent in 1995.

Imports into the European Union and Japan amounted to $107.8 billion (3.7 per cent) and $75.4 billion (19.7 per cent). Though relative to the total Japan was a major importer, the US clearly dominated in absolute magnitude.

What is more, merchandise exports to China in 2003 stood at $28.4 billion, $44.9 billion and $72.5 billion respectively in the case of the US, European Union and Japan. The US sucks in commodities from China, but sends little back in return.

Finally, in recent years, China has provided space for foreign firms in its domestic market. As Nicholas Lardy, then of the Brookings Institution, wrote in 2002:

At the turn of the twenty-first century in China, "foreign manufacturers led by Motorola, Nokia and Ericsson had captured 95 per cent of the market for cellular phones. Coca-Cola was the dominant supplier of carbonated beverages with a market share fifteen times its closest domestic competitor. Its operations in China have been profitable for more than a decade, and Coca-Cola expects China to emerge as its largest Asian market in 2002 or 2003. McDonald's and Kentucky Fried Chicken, with almost 900 outlets between them, dominated China's rapidly growing food market. Kodak had captured half the market for film and photographic paper. Volkswagen, through two separate joint ventures, controlled more than half the domestic automobile industry. Carrefour, the French company, had become China's second largest retailer only five years after entering the market. And, as unlikely as it might have once seemed, Proctor and Gamble had more than half of what is undoubtedly the world's biggest shampoo market."

Thus, the problem is not one of Chinese mercantilism, but one of lack of competitiveness of the US. Not surprisingly, the US has performed poorly despite the fact that the yuan is pegged to the dollar.

With the dollar depreciating vis--vis the euro and the yen, it is the EU and Japan that should lose out in trade with China, not the US.

Despite all this evidence in its favour, China is feeling the heat, as shown by Li Ruogu's response. This is the result of China's reform-driven dependence on exports in general and exports to the US in particular.

With exports amounting to 33 per cent of GDP and the US accounting for 37 per cent of China's total merchandise exports of $438.4 billion, the US market is too important for China for US views to be ignored.

Not surprisingly, expectations are that China would soon loosen strings on the yuan, which has since 1995 been allowed to fluctuate only within an ultra-narrow 0.3 per cent band around 8.28 yuan to the dollar. That band is now expected to widen.

But this is likely to be too slow to satisfy the US because of what investment banker Henry Liu sees as China's "residual commitment to socialist principles", which makes it hope that it can "reap the euphoria of market fundamentalism without succumbing to its narcotic addiction."

The US and the rest of the world will have to find some other answer to the problem of the weakening dollar generated by the twin deficits in the US.

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