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Edging towards a Currency War?

Feb 14 , 2011

As the US mid-term election looms and the effect of the global financial crisis (GFC) lingers, the Currency Reform for Fair Trade Act (HR 2378) is the latest salvo in US–China trade frictions. The two economic powerhouses are edging towards a currency war. What is at stake? The world’s leading economy, the United States, trapped in a financial crisis, mounting public debt, and double digit unemployment rate, is eager to export out. The world’s second largest and fastest growing economy, China, finds its currency a handy scapegoat. The historical mistake of the 1930s is on the verge of repeating itself. A currency war, if full-fledged, would bring down the global trading system. 

As many have pointed out, the fundamental cause of global imbalances is structural: overspending in the US and too much savings in China. The world has embarked on a rebalancing act since the outbreak of the GFC. The transition, however, has been made more difficult by the GFC and the accompanying stimulus policies that exacerbate the underlying structural imbalances. Exchange rates, though not the root cause, are the most visible symptom and contentious factor in global imbalances. Centered on it, a series of interconnected issues, ranging from trade imbalances to international monetary system, and from the accumulation of reserves to global economic governance, are awaiting solutions. 

Before we tackle any of these issues, some stocktaking is necessary. The US is the largest destination for Chinese exports and China is the largest foreign investor in US government debt. The two economies combined represent more than a third of the world’s total output and over a half of the world’s economic growth. Perhaps the most dramatic background is that China is on course to overtake the US as the world’s largest economy as early as the 2020s, the first in a century since the US replaced the United Kingdom in the 1920s as the world’s leading economic power.

Despite their shared prowess, the two economies embody very different growth models. While the US economy is often deemed driven by insatiable consumer demand, China’s growth is mostly export-led and investment-driven. China’s gross national savings rate has recently exceeded 50 percent: only 20 percent comes from household and the remaining corporate and government. China’s investment rate has stayed above 40 percent since 2003, and reached 47 percent in 2009, whereas in the US private investment only accounts for less than a sixth of the economy. US personal savings rate was at a historical low of 1 percent in early 2008 and recovered to 5 percent in late 2009, which led to some improvement in the country’s current account.

The complementarities between the two growth models, e.g., “you do the saving and I do the spending”, created interdependence and stability. In a world of contracting global demand, however, the very growth models have become a source of conflict and frustration. By accounting identity, the current account balance is the difference between savings and investment. A deficit country thus needs to increase savings, consume less, and reduce investment to return to a sustainable track. Already more than two thirds of its GDP, the US’s share of consumption is still on the rise because of the stimulus plan. In contrast, China’s consumption share, a mere 35 percent, stagnates as most stimulus funds are channeled through investment. If the trade deficit ought to contract over the medium term and the high savings rate remains persistent in China, the burden of adjustment is going to be determined by the trade account.

China’s accumulation of foreign reserves of $2.5 trillion, largely in US government securities, is sometimes viewed as a deliberate mercantilist policy of holding down the RMB. But China’s hoarding of reserves did not really take off until the aftermath of the Asian financial crisis. Its growth miracle started long before that. Underneath the exchange rate lay structural imbalances between the world’s top two economies and the very different ways of developing an economy.

Revaluing the RMB, though in China’s long-term interest, won’t solve America’s trade deficit dating back to the 1980s. A change of the relative price won’t shift the assembly lines and manufacturing jobs back to the US. Nor will it lead to significant improvement in US trade balance as history has shown repeatedly. Between 2005 and 2008, the RMB appreciated against the US dollar by 22 percent, yet the bilateral trade deficit continued to rise. The Japanese yen has risen from 350 yen per dollar in the 1970s to around 80 yen per dollar today, and yet the US still runs quite a big deficit with Japan. Without collective action, any unilateral appreciation of the RMB would simply shift US demand to other exporting countries.

China’s surplus against the US is structural and partly the result of international division of labor. Fifty-seven percent of China’s total exports are processing trade where parts are imported, assembled, and only to be re-exported. China’s entire trade surplus is now accounted for by processing trade while traditional trade records a net deficit. Most of the processing trade is operated by multinational firms (many of them American) which have the networks for locating input processing and international marketing. In this sense, a US trade war against China may very well include one part of the US against another.

Exchange rates, though important, are only part of the package for the global rebalancing where surplus countries have to consume more and deficit countries save more. Any piecemeal approach hinged on currencies risks igniting a currency war and will prove counterproductive. A consensus is forging among global policymakers on a long-term adjustment path. Indeed, China’s forthcoming 12th five-year plan has put forward a comprehensive package transforming the export-led growth economy into one driven by sustainable domestic demand. The dispute, however, lies in the timing, speed, and scope of the adjustment process, which ultimately decides the burden sharing of rebalancing.

Chinese policymakers are facing a dilemma and they may very well be aware of it. On the one hand, a quick and sizeable appreciation in the RMB may cause massive unemployment and social upheavals. Such an appreciation could drive out of business many labor intensive manufacturing companies in the east coast, many of which survive on a slim profit margin of two to three percent. A five percent appreciation, though insignificant compared to the US demand, could eliminate the tiny profit margin altogether. On the other hand, however, a small and gradual appreciation risks creating a one-way bet against the RMB in which speculative money continues to flow in. This may lead to bubbles in the real estate and equity markets, whose ultimate bursting would derail China’s plans to being the world’s top economy much as it did to Japan exactly a quarter century ago.

The relevant question is whether China in 2010 will become Japan in 1985. Are there ways to avoid a repeat of the “Plaza Accord” and yet achieve global rebalancing on mutually acceptable terms?

There is no easy and quick fix. Besides making the Chinese more American and the American more Chinese, one quick but certainly not easy fix would be further opening up the US markets, particularly on environmental and other advanced technologies that China has long wanted to import. Otherwise, China can’t afford adjusting solely through sharply falling exports.

Since an abrupt nominal appreciation of the RMB is not viable, one alternative is to increase wages for workers, especially blue-collar and rural migrant workers. This has two benefits. Firstly, it lifts the purchasing power of the relative poor and helps shift demand from external to domestic. Secondly, it circumvents the politically testy and frustrating nominal exchange rate and yet achieves rather sizeable real appreciation as measured in unit labor cost. This, however, may create an unemployment problem.

To prevent massive unemployment and the resulting social upheaval, Governments can put in place targeted subsidies to exporters or tax credits for purchases of tradable goods such as household appliances. Tax credits, like wage increases, not only help boost domestic demand but also improve income distribution, both key elements of remaking the Chinese economy. Subsidy, however, may not be compliant with WTO rules. Given the limited resources and the need to prioritize, policymakers could consider making preferential tax treatment to key exporting industries that are instrumental in generating learning-by-doing and technology spillovers.

The road of adjustment will be gradual, long, and bumpy but the stakes are too high. To resolve differences, both bilateral and multilateral mechanisms have to be put into full use. Bilaterally, the US-China Strategic and Economic Dialogue remains the highest level bilateral forum to engage in economic and strategic discussions. Multilaterally, the G-20 is emerging as the premier forum for international governance. A de facto core group between the US and China, dubbed the “G-2”, is forming within the G-20. Both countries may find it in their interest to embed bilateral negotiations in a multilateral forum. After all, the exchange rate is not a bilateral issue. Nor is the global rebalancing or the reconstruction of the world economic order.

Miao Yanliang is an economist with the IMF and previously taught at Princeton University’s Woodrow Wilson School.

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