China's currency valuation is eliciting ever growing criticism and resentment among some policymakers in the United States, and this in turn is fueling controversy and confusion among policymakers in China. But there is a way of resolving the currency dilemma — whether to stand pat or to revalue — that would be sensible and beneficial to China, the U.S., and the world economy.
That the partly-convertible Chinese yuan is tightly pegged to a fully convertible U.S. dollar is itself an anomalous situation. “Partial convertibility” means that, while holders of liquid yuan assets can use them to purchase current imports of goods and services, they cannot normally use yuan to purchase foreign stocks, bonds, other financial assets or for direct foreign investment.
From the point of view of American critics of China's currency peg, the fact that the U.S. bilateral trade deficit with China in 2004 was $160 billion while two-way trade between China and the U.S. was nearly $220 billion (China's imports from the U.S. were less than $60 billion) is seen as confirmation that the yuan is undervalued, that the tight peg of 8.28 yuan per U.S. dollar represents “manipulation” of the yuan's value to the detriment of U.S. exports, and that the yuan should be revalued or the dollar peg removed.
In a report issued this week, the U.S. Treasury Department reflecting pressure from Congress, warned that unless Beijing changed its currency policies it could be labeled a currency manipulator, a step that might lead to sanctions.
China's trading partners in Asia and Europe are no less critical of the yuan's dollar peg, although they are less vociferous than U.S. critics, preferring to let the U.S. do the heavy lifting on this matter. Because the dollar's value has declined relative to the euro and the yen in global exchange markets, other countries whose currencies float criticize China's dollar peg because it effectively depreciates the yuan relative to non-dollar currencies. As a consequence, exports by these other countries are less competitive with China's exports than they otherwise would be, while China's exports to these countries are boosted.
From China's point of view, any appreciable change in the dollar peg might lead to still greater difficulties and more heated criticism than does the present policy. For example, if the peg were lowered by, say, 15%, to 7 yuan per dollar, China's bilateral trade surpluses with the United States would probably not change much nor would its global trade surpluses be much affected. Underutilized production capacity in China's booming export sector is so large that production would continue even if profit margins were narrowed. Moreover, a lowered peg would very likely increase China's imports of oil and metal ores, adding further demand pressures to these already inflated markets and probably generating additional criticism against China by other consuming countries including the U.S. Chinese policymakers also fear that, were the peg to be changed, more “hot” money would flow into China in anticipation of further adjustments in the future, thereby contributing to inflation and further “overheating.”
Finally, and probably most significant, if China were to allow the yuan's exchange value to float while refusing to liberalize on the capital account, pressure to make the yuan fully convertible would grow. In each of the last two years China has allowed about $4 billion to $5 billion of capital exports to occur for special purposes involving acquisition of particular foreign assets favored by China's policymakers — such as oil refineries and high-tech industry (for example, the Lenovo acquisition of IBM's PC business). However, these transactions amount to only a drop in the bucket. Behind them loom liquid deposits in the major Chinese banks of more than 21 trillion yuan ($2.5 trillion), an amount that is 180% of China's GDP. The holders of these huge yuan assets include business enterprises, urban and rural households, agricultural deposit holders, and other entities. If as much as 10% of these holders of yuan assets were to seek to diversify their portfolios by acquisition of foreign assets, the yuan might be as likely to depreciate as to appreciate relative to the U.S. dollar.
Resolution of China's currency dilemma lies in synchronizing two policy changes: a further unblocking of China's capital account along with a broader float of the yuan on foreign exchange markets. China's current account surpluses would continue to generate a large supply of foreign currencies, while substantially unblocking the capital account and allowing convertibility of perhaps 5% to 10% of liquid bank deposits would generate additional demand for foreign currencies. China's huge foreign exchange reserves ($660 billion) would provide an adequate cushion for any short-term volatility that might ensue.
By allowing a modest and gradually rising proportion of liquid yuan assets to be freely convertible into dollar, euro, and yen assets, China's policymakers would contribute measurably to improved efficiency in the allocation of China's own large capital resources, while at the same time contributing to more effective functioning of the global economy and neutralizing foreign critics of China's currency policies.
Mr. Wolf is senior economic adviser and corporate fellow in international economics at the RAND Corporation, and a senior research fellow at the Hoover Institution.
This commentary originally appeared in Asian Wall Street Journal on May 20, 2005. Commentary gives RAND researchers a platform to convey insights based on their professional expertise and often on their peer-reviewed research and analysis.