Clarifying the Yuan Debate


(Far Eastern Economic Review)

by Charles Wolf, Jr.

February 1, 2008

In 2007, China's current account surplus—the excess of its revenues from exports of goods and services, holdings of foreign assets, and foreign remittances—was approximately $300 billion, two-thirds of which represent its bilateral surplus with the United States. China's global current account surplus is about 10% of its GDP.

The U.S. current account deficit in 2007 was about $800 billion, nearly 6% of the U.S. GDP. China's bilateral surplus with the U.S. is thus one-quarter of the global U.S. deficit.

These deficit and surplus relationships between the U.S. and China, respectively, are actually of substantial mutual benefit to both countries. China's surplus contributes to sustaining its high growth rates, and the U.S. deficit contributes to easing inflationary pressures while enhancing average living standards through the competitive price and quality of imports from China (problems of contaminated food, and lead and other noxious paints on imported toys warrant serious attention, but do not negate the mutual benefit).

To finance the current account imbalances requires offsetting imbalances in the capital accounts of China and the U.S.: Specifically, China acquires U.S. assets in the form of debt, equity investment, or direct investment in the U.S. These transactions, while contrary to the normal prognosis of economic theory—“normally” more developed economies (e.g., the U.S.) are expected to have export surpluses with less-developed economies (e.g.,China), and the former would acquire capital assets from the latter—are also of mutual benefit to both countries.

To the extent that the accumulating imbalances are of concern, there are right-and-wrong, better-and-worse ways of modulating them. The wrong way is to attempt to force China to revalue the yuan from its present value of 12-13 cents to perhaps 17-18 cents. The reasoning behind this view is that the revaluation would make U.S. imports from China more expensive in dollars and would therefore decrease; while U.S. exports to China would become less expensive in yuan and would therefore increase.

While this reasoning appears plausible and indeed seems to have persuaded the congressional leadership of both the Democratic and Republican parties, it is nonetheless fundamentally wrong.

A country's current account deficit (or surplus) depends on and is defined by the excess (or shortfall) of its gross domestic investment above (below) its gross domestic savings. Gross domestic investment in the U.S. exceeds domestic savings by 5% or 6% of the GDP. China's extraordinarily high domestic savings exceeds its domestic investment by about 10% of its GDP. Revaluation of the yuan would have only a small and transitory effect as long as the fundamental imbalances between savings and investment in the two economies persist.

To reduce the bilateral imbalances between China and the U.S. requires carefully crafted policies to boost consumption (lower savings) in China, and slightly raise savings in the U.S.

Appropriate remedial policies for China lie in accelerated implementation of its social security system, expansion of consumer credit, wider dissemination of credit and debit cards, and improved credit ratings for consumers and for institutions that provide consumer credit.

Remedial policies for the U.S. lie in curbing government spending (because government spending reduces gross savings), instituting personal retirement accounts to supplement the defined benefits of the Social Security system, establishing a graduated consumption tax, or some combination of these measures.

Mr. Wolf holds the corporate chair in international economics at the RAND Corporation, and is a senior research fellow at the Hoover Institution.

This commentary originally appeared in Far Eastern Economic Review on February 1, 2008. Commentary gives RAND researchers a platform to convey insights based on their professional expertise and often on their peer-reviewed research and analysis.