Our Misplaced Yuan Worries


Dec 15, 2007

This commentary originally appeared in Wall Street Journal on December 15, 2007.

It's conventional wisdom that bipartisanship results in improved public policy. That this is not so is strikingly illustrated by a bill, supported by Democratic chairmen and ranking Republican members of the relevant committees in the Senate and House, that would punish China for its "misaligned" currency (the yuan). Its mistaken premise is that this misalignment threatens our prosperity by causing America's large current account deficits with China.

In 2007, China's current account surplus — the sum of its trade surplus, and net receipts from foreign assets and foreign remittances — will be nearly 10% of its GDP, or about $300 billion. Two-thirds of this represents a bilateral surplus with the U.S. The U.S. global current account deficit in 2007 will be about $800 billion, nearly 6% of the U.S. GDP. Thus, China's bilateral current account surplus with the U.S. is one-quarter of the global U.S. deficit.

In 2005, the yuan was worth 12 U.S. cents. It is currently worth 13.5 cents. Many believe that if the yuan's exchange value were to increase further, perhaps to 17 cents or 18 cents, the bilateral imbalance between the two countries would be substantially reduced, if not eliminated. China's exports to the U.S. would thereby become more expensive in U.S. dollars and would therefore decrease, while China's imports from the U.S. would become less expensive in Chinese yuan and therefore would increase. If China fails to make this currency adjustment, the pending legislation in Congress would impose a tax on imports from China to offset the putative currency undervaluation.

This reasoning, though plausible, is wrong. A country's global current account deficit depends on the excess of its gross domestic investment over gross domestic savings. Gross savings in the U.S. are about 10%-12% of GDP, largely consisting of corporate depreciation allowances and retained corporate earnings. On the other hand, gross domestic investment is 16%-17% of GDP. The difference between the two comprises the U.S. current account deficit.

China's current account surplus is the mirror image of the U.S. imbalance. Gross investment in China is above 30% of its GDP, but its savings are even higher, above 40%.

While the appreciation of the yuan might initially raise U.S. exports to China and lower China's exports to the U.S., these effects would be small and transitory as long as the imbalances between savings and investment in the two economies persist. Japan and Germany — two countries with perennial current account surpluses — illustrate the point.

While Japan's yen has appreciated against the dollar in the past several years, its current account surplus is largely unchanged, because Japan's domestic savings have continued to exceed its domestic investment. The euro has appreciated 30% relative to the dollar, yet Germany maintains a large global current account surplus. That's because the German economy maintains an excess of savings over investment. (The economies of most other eurozone countries show a savings shortfall, and continue to incur current account deficits.)

In both Germany and Japan, the excess of domestic savings over domestic investment persists and hence their current account surpluses persist, notwithstanding their currencies' appreciation.

To reduce the bilateral imbalances between China and the U.S. requires more carefully crafted policies than revaluation of the yuan, else the results could be perverse. If correcting China's imbalance were sought by increasing gross domestic investment to match domestic savings, rampant inflation above the present 6.6% annual rate (already twice that of a year ago) could result — because soaring demand for materials, plant and equipment would in the near term sharply boost their prices. This is a sequence China is already experiencing. If correcting the U.S. imbalance were sought by lowering investment to a level closer to the U.S. current savings rate, a serious recession would likely result.

Effective remedial policies for China lie in raising domestic consumption (reducing domestic savings) by 4% or 5% of GDP through such measures as wider dissemination of credit and debit cards and other consumer credit instruments. Remedial policies for the U.S. lie in raising current savings by 2% or 3% of U.S. GDP, through curbing government spending, instituting personal retirement accounts to supplement the defined benefits of Social Security, establishing a graduated consumption tax, or a combination of these measures.

In the U.S., such measures have been advocated by some members of both parties. But more important than their potential bipartisan support, they would warrant nonpartisan support because, unlike currency realignment, they would actually address the underlying sources of the U.S. and Chinese imbalances.

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