Opinion

For a more flexible currency

By Yao Yang (China Daily)
Updated: 2010-09-15 11:39

The US congress will hold a hearing today to judge whether China has revaluated its currency to its "requirement". On June 19, 2010, the People's Bank of China (PBOC) announced a policy re-pegging the yuan to a basket of currencies. But the Americans, eager to see a faster increase in the value of the Chinese currency, don't seem to be happy with the "slow revaluation". Hence, they are pressuring China again to revaluate the yuan faster.

The new wave of pressure is no more than an effort to make China the scapegoat for America's poor economic performance. The fact is, even a 20 percent increase in the yuan's value, as some prominent American scholars have demanded, will not help the US economy greatly.

According to a recent joint study of American and Chinese scholars, who used a computational general equilibrium model covering the major economies, a 20 percent rise of the yuan against the US dollar will increase American employment only marginally (0.16 percent). And it will raise American consumption by a mere 0.2 percent and GDP growth by just 0.16 percent.

In contrast, it will worsen American trade balance by $10.5 billion, because the substitution effect between Chinese exports and US-made goods is very weak.

But a 20 percent rise in the yuan's value will hurt the Chinese economy severely. Although the trade balance will be only marginally affected, dropping by $10.4 billion, which is a small fraction of China's total trade surplus, its employment and domestic consumption will fall by 3.03 percent each and its GDP will drop by 3.18 percent. So, it does not make much sense for the US to demand a large revaluation of the yuan unless it just wants to punish China. And if that is the case, it is perfectly reasonable for Chinese policymakers to firmly reject the American demand.

The same study has also found that a gradual revaluation of the yuan does not harm the Chinese economy greatly. For example, if the yuan rises by 5 percent against the greenback, employment and consumption in China will drop by only 0.74 percent and 0.57 percent, and its GDP will decline by 0.56 percent. Plus, the trade balance will improve by $3.47 billion.

Besides, a moderate revaluation of the yuan will bring sizable benefits to China, the most significant being lower inflationary pressure, including those of higher asset and real estate prices. One of the fundamental laws governing a country's catch-up process is the so-called Balassa-Samuelson effect. Worked out independently by Hungarian economist Bela Balassa and American economist Paul Samuelson in the early 1960s, it says (roughly) that a country's currency will experience real revaluation when it catches up with advanced countries in terms of per capita income.

So, a real revaluation of the yuan should make Chinese goods and assets more expensive for people abroad to buy. This means either a more expensive yuan, that is, revaluation of the yuan, or higher prices of Chinese goods and assets, that is, inflation and asset/real estate bubbles. Inflation and asset/real estate bubbles benefit no one. But the yuan's revaluation at least increases Chinese people's purchasing power when it comes to buying foreign goods and services. Therefore, to tackle the Balassa-Samuelson effect, China would do better to choose the yuan's revaluation over inflation.

PBOC's sterilizing bonds help ease inflationary pressures while maintaining a stable value of the yuan. But this entails forced savings, especially when the economy is on an expansionary path and banks prefer lending to the real economy to buying the sterilizing bonds. The forced savings become part of China's current account surplus and ultimately show up in its official foreign reserves.

This would create a vicious circle: PBOC issues sterilizing bonds to stabilize the yuan's value, leading to more accumulation of foreign reserves, which requires the yuan to rise further in value, which in turn prompts PBOC to issue more sterilizing bonds. The only way to break this vicious circle is to allow the yuan to revaluate.

Given the competitiveness of Chinese products in the world market, moderate revaluations are unlikely to worsen China's position. Chinese workers are paid only one-fourteenth of what Japanese workers get and one twelfth of what South Korean workers receive. Moreover, labor productivity increases much faster than wages. One worker today is as productive as 12 workers were 20 years ago, but his/her salary is only 4.7 times of what his/her predecessor got two decades ago.

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The cost of labor per unit of output has declined and the competitiveness of Chinese exports improved. Assuming that the unit labor cost did not change in other countries, the gap between productivity growth and wage growth in China would have allowed the yuan to rise 4.3 percent in real terms each year without lowering China's competitiveness in the last 20 years. And since in reality, the unit labor cost has increased in many countries, the room for the yuan's revaluation would have been larger.

The distress tests Chinese exporters have undergone reflect only their wishes, not reality. Experienced exporters factor in the risk of the yuan's rise when they sign contracts with foreign buyers. Between 2005 and 2008, the yuan rose more than 5 percent each year, during which China's exports actually doubled. In the first half of 2010, exports grew by 42 percent taking the total export volume back to the pre-global financial crisis level.

Inflationary pressures are back, and real estate prices are rising despite concerted government efforts to control them. Allowing a larger band for the yuan's value to rise will help the government deal with inflation and real estate prices, because a more flexible exchange rate - not a passive response to foreign pressure - is in China's own interest.

The author is a professor and director of the China Center for Economic Research, Peking University.