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China's currency: The limits of patience

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COMMENTS

16 March 2010 10:48

As predicted, the argument over the future of China's exchange rate policy is heating up. The US Congress has told the Obama Administration that it wants the US Treasury to designate China a 'currency manipulator'. Leading voices in the US are calling for a turn to 'policy hardball' and for Washington to increase the pressure on Beijing. For its part, Beijing argues that US protests over the RMB amount to little more than protectionism. A few thoughts:

1. It is blindingly obvious that China is indeed manipulating its currency. China has been indulging in massive, one-way intervention in the foreign exchange market, and has been doing so for some time. Indeed, with foreign exchange reserves of more than US$2.4 trillion, it's pretty certain that this is the single biggest FX intervention in history.

2. The level of China's exchange rate matters. Economists rightly point out that it's the real exchange rate rather than the nominal exchange rate that is more important. But changes in the nominal exchange rate are a good way to get changes in the real rate. More generally, arguments that suggest that the level of China's exchange rate doesn't really matter are bizarre: they are effectively saying that one of the most important prices in the economy is irrelevant – something which of course Beijing itself does not believe for one second.

3. While we know that China's exchange rate is undervalued, we don't know by how much. There are a wide range of estimates available, and depending on which one you pick, you get very different estimates of the degree of undervaluation, ranging from approaching 40% undervaluation to almost no undervaluation at all. 

More generally, estimating so-called 'equilibrium' values of the real exchange rate turns out to be very tricky and extremely sensitive to the model you use and the assumptions you make. The resulting uncertainty represents a major constraint on policy advice: just how much should China revalue by? Since the honest answer appears to be 'we're not sure', that doesn't make for a massively compelling piece of advice.

4. The obvious alternative to picking a percentage target for revaluation – leave it to the foreign exchange markets to set the value of the RMB – does not look like a particularly attractive proposition hot on the heels of the biggest demonstration of financial market failure since the 1930s. Selling that one is going to take some effort right now.

5. Moreover, maintaining an undervalued — Beijing would probably prefer the term 'competitive' — exchange rate has in fact been a remarkably successful policy as far as China is concerned (which is of course more evidence that the level of the exchange rate does indeed matter). This success means that it's hardly a surprise Beijing is reluctant to surrender this policy tool without something in return.

6. Finally, it's also clear that China's exchange rate policy is now having adverse consequences for the rest of the world. In particular, it places the global trading regime under strain by fuelling protectionist pressures. And there's an unfortunate circularity at work here. China's exchange rate policy creates resentment among other trading partners, which helps undermine support for an open trading system. However, many of the proposed responses to the manipulation of the RMB — for example, levying tariffs on Chinese imports – would themselves wreak severe damage on that same trading system, precipitating the very crisis that Beijing's critics are warning of.)

These six points suggest that resolving the policy debate over the RMB is likely to be a tricky proposition. Which is why the conventional argument has been that the best hope is for China to opt to exit from its current policy regime for its own domestic reasons; external pressure only makes Beijing reluctant to be seen to submit to international demands. Trouble is, this conventional argument has been around for a while, and it now seems that the patience required for this approach is running out. 

Photo by Flickr user Robert S. Donovan, used under a Creative Commons license.

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