commentary

(South China Morning Post)

September 26, 2003

Behind the Rhetoric

by Charles Wolf, Jr.

In the debate over China's exchange-rate policy, most of the chatter has been devoted to an erroneous argument, while a second argument that is both valid and crucial has been neglected. The erroneous argument is that China's failure to revalue its undervalued currency—also sometimes referred to as its "manipulation" of the yuan—is responsible for a substantial loss of US jobs, especially in manufacturing.

The error of this argument lies in the fact that the job losses over the past few years—about 700,000 in the first three quarters of this year alone—is mainly attributable to the innovative character of the US economy, and has little to do with China or any other of America's major trading partners.

An annual growth in US labour productivity of about 4 per cent means that, as a result of better equipment, training and management, the level of employed labour that produced last year's gross domestic product could produce 4 per cent more this year. In fact, the US economy's rate of growth in the last year has been only between 3 and 3.5 per cent, which means that total employment (135 million) has decreased by about half of 1 per cent—the difference between 4 per cent productivity growth and 3.5 per cent GDP growth, that is approximately 700,000 jobs.

Unfortunately, nearly 90 per cent of this decrease has been concentrated in manufacturing. This concentration results from the fact that labour productivity in US manufacturing has increased at an especially rapid pace, so that the sector currently accounts for the same fraction of GDP (about 16 per cent) as it previously did before the loss of manufacturing jobs. Consequently, US unemployment is mainly attributable to factors in the domestic economy. The nominal exchange rate of the yuan has remarkably little to do with explaining the so-called "job-loss" recovery of the American economy.

The valid, but neglected, argument about China's currency is different. China's failure to move from partial convertibility of the yuan (which is confined to trade in goods and services), to full convertibility (including international capital transactions), results in a misallocation of China's own capital resources, as well as an inability of even its policymakers or foreign-exchange markets to accurately estimate the yuan's "true" exchange value.

Its value in terms of the "market basket" of goods and services it can buy—what economists refer to as its "purchasing power parity"—is probably between 30 per cent and 40 per cent greater than the nominal exchange value. Of course, the relevant "market basket" here includes many categories of goods and services that are not internationally tradeable—such as domestic personal services, property and construction—and hence do not affect international transactions or the yuan's nominal exchange value. But capital transactions do affect exchange rates, often decisively. For example, if holders of dollar, euro, or yen assets wish to invest in China, they can use them to buy yuan, thereby tending to prop up its exchange value. However, if holders of yuan assets wish to acquire dollar, euro or yen assets—for example, equities, bonds or property—they are unable to do so. China allows, indeed encourages, foreign capital to flow into China, but prevents ordinary domestic Chinese capital from flowing out.

The principal exception to this has been the use by China's central bank of the economy's surpluses on current-account transactions to purchase US Treasury bonds, thereby adding to its official foreign-exchange reserves. In the past three years, reserves have more than doubled, from US$168 billion to $357 billion.

Thus, if the individuals, households and companies in China which hold trillions of yuan in bank deposits or other repositories want to diversify their holdings to hedge the risks of holding only yuan assets—or, in some cases, to seek higher returns by acquiring foreign assets—these transactions are blocked because of the yuan's inconvertibility for normal capital transactions.

It is impossible to determine the extent to which the holders of yuan would want to buy foreign assets. However, some guesses can be made. For example, China's annual savings rate of 30-35 per cent of GDP—the highest of any major national economy—generates annual savings of about 3.5 trillion yuan (HK$3.2 trillion). If the yuan were to become fully convertible, foreign-asset purchases could amount to between US$12 and US$35 billion in the near term, even with only, say, 3 per cent of these holdings converted. To compare, 3 per cent is about one-third the share of Japan's savings currently spent on foreign equities, bonds and other foreign assets.

The outflow of capital that would be triggered by full convertibility would then exceed China's already diminished current-account surplus with the rest of the world. As a result, the yuan might be as likely to depreciate—that is, become less expensive, relative to the US dollar or euro—as it would be to appreciate. The real foreign-exchange value of the yuan can only be determined after it becomes fully convertible.


Charles Wolf is a senior economic adviser and corporate fellow in international economics at RAND, a think-tank based in Santa Monica, California, and a senior research fellow at the Hoover Institution.

This commentary originally appeared in South China Morning Post on September 26, 2003. Commentary gives RAND researchers a platform to convey insights based on their professional expertise and often on their peer-reviewed research and analysis.