Dollar vs. Yuan: Exchange Rates Aren't the Problem. Or the Solution

While President Obama is in Shanghai, one of the hottest issues on the table will be the exchange rate between the U.S. Dollar and China’s Renminbi. In the past few weeks, commentators like New York Times columnist Paul Krugman have argued that Obama’s top priority should be to pressure China into strengthening its currency, in order to “rebalance” the global economy. I disagree. A more flexible exchange rate – and the stronger Renminbi that would likely result – would be a step in the right direction. But it’s not a silver bullet, and would have little effect in the absence of more substantive economic reforms. In my view, the focus on currency is a huge distraction from far more pressing issues.

Krugman is correct that a rebalancing needs to take place. The current situation, in which China runs larger and larger trade surpluses, and lends the proceeds back to fuel ever-rising consumption in the United States, is not sustainable indefinitely, especially as the Chinese economy grows to rival America’s in size.

According to conventional economic theory, flexible exchange rates play a vital role in correcting such imbalances. When a Chinese exporter sells a product to the U.S., it receives dollars in return. Those dollars don’t just disappear; they stay in China until someone wants them to buy products from America or invest in American assets. For quite some time now, China sells more than it buys from the U.S., and brings in more capital than it invests abroad, which means that there aren’t enough people who want to use all the dollars that keep flowing in. Just like any other market, when the supply of something – in this case dollars – outstrips demand, its price should drop. The dollar depreciates, making U.S. goods cheaper and more attractive to Chinese consumers, while the Renminbi appreciates, making Chinese goods more expensive in America, eventually closing the gap in trade.

The Chinese government, though, isn’t letting that happen. Instead of letting those excess dollars sell for a lower price in Renminbi, it steps in and buys them at the current exchange rate, and holds them as reserves. By keeping the Renminbi artificially cheap, Krugman and other critics contend, China gains an unfair trade advantage. If only the Chinese would stop interfering, and allow the dollar to find its true level, American products would become more competitive and this dangerous imbalance would correct itself.

Sounds good, but the problem is we’ve been here before. In the early 1980s, Japan was running a chronic trade surplus with the United States, and accumulating dollar reserves on a massive scale. Economists argued that an undervalued Yen was to blame. So in September 1985, the central banks of the U.S., Japan, Britain, France, and West Germany agreed on what became known as the Plaza Accord. Over the course of the next two years, they intervened heavily in global currency markets to bring the value of the dollar down by over 50% against the Yen, from around 250 JPY/USD to 125.

The outcome baffled and frustrated economists. While the cheaper dollar had a significant effect in reducing America’s trade deficit with Europe, Japan’s trade surplus with the U.S. barely budged – in fact, it grew. How could this be? Why didn’t the new exchange rate make U.S. goods more competitive, and erase the trade imbalance with Japan?

The reason was structural. The post-war Japanese economy had been based on export-led growth. Its financial system, supply chains, and distribution channels were all geared to push exports. The cheap Yen was one pillar supporting this structure, but when that changed, other factors swung into effect to maintain the status quo. Following the Plaza Accord, the Japanese banking system flooded the economy with cheap credit to fuel continued expansion, and brushed bad debts under the rug. On the equity side, Japan’s system of corporate crossholdings within keiretsu industry groups tended to produce a greater emphasis on preserving market share than on maximizing profits. The country’s domestic distribution system, virtually impenetrable to outsiders, created a formidable barrier to imports, regardless of price.

Exchange rates are prices, but they only matter so long as prices matter. We normally assume that prices do matter, but soft budget constraints and subsidies embedded in the structure of an economy can blunt or entirely negate the impact prices should have. That’s what happened in Japan.

China, too, has relied on an export-led model to fuel its stupendous growth these past 30 years. With the collapse in overseas demand caused by the global financial crisis, much talk has been devoted to the need to foster domestic consumption as an engine of growth. But China’s actual response to the crisis has been to rely on an explosion of cheap lending and state spending to freeze the existing economic structure in place, in the interests of social stability. China’s stimulus program has tilted the playing field in favor of large state-owned companies which often pursue other goals besides profit and are regarded as “too big to fail.”

An undervalued Renminbi may be part of the problem – its peg to a weakened dollar is certainly putting the squeeze on other countries that compete with Chinese exports to the U.S. But my concern is that, even if President Obama succeeded in pressuring China to strengthen the Renminbi, we’d be looking at a replay of the Plaza Accord.

Rather than face a difficult economic adjustment, China would find other ways to bolster its export sector, and the imbalance would persist. America’s interests, and the world’s, would be much better served by encouraging China to open its markets to greater competition, foster capital markets that allocate resources more efficiently, and develop a social safety net that makes labor markets more flexible and unlocks the savings of China’s vast population. The President can also help by sending a clear signal that America welcomes Chinese investment, offering China a more productive way to use the dollars it does earn. If progress is made on these fronts, it well help create an environment in which prices do matter, and exchange rates can make a difference in producing lasting outcomes.

If President Obama wants to achieve real results, he should press China on market-oriented reform, not exchange rates.

Comments

[Moon Kil Woong:]

China's vast savings of it's population is centrallized in 1-2% of the population that has most everything already. Their auto industry has more than a 100% tax unless you buy a Chinese made one. Their LEDs are 66% cheaper because they refuse to regulate or enforce patent laws. Their clothes are 8x cheaper because, well they make them. 90% of their comuters use illegal or trial versions of anti-virus software, OS and word processing, and the like.

Indeed the author is right that the imbalance goes way beyond currency. The WTO has failed to enforce a single rule of its own on China and the US fails to enforce any rules either. Perhaps that's why they get along so well.

The reasons at to how this crooked relationship works is all to clear. The US is dependent on China to cover up the Federal Reserve's blatant and purposeful spewing of excess money supply into banks to enrich them and the government's desire to enrich their friends annually with their out of control deficit spending so they don't have to suffer the wrath of voters for doing so. As for the WTO and China, China is simply too big too ignore and too big to follow the rules (sort of like derviatives are to the financial community).

The chances you get China to level the playing field while it remains the only global engine of growth (even if it is driven through a giant liquidity bubble similar to the US) are just about zero. Thus Obama's visit is pure tokenism the same way Bush Jr.'s was. If we got down to arguing over real issues it would go something like this:

US: You are being unfair.
China: You are being unfair.
US: You are devaluing your currency.
China: You are supressing your currency.
US: You are stealing all business and not buying our stuff.
China: You are giving us junk paper and using us to keep your inflation low. Fix your own country before telling me what to do.
US: Ok then don't tell us how we run our monetary policy. If you want to complain about currency debasement float your own currency.
China: Ok so the status quo it is
US: I suppose so. Do you want to talk about trade barriers?
China: No.
US: I didn't think so.
China: Do you want to talk about a new reserve currency?
US: No.
China: I didn't think so.

Nov 16 06:22 AM

[marduk:]

The Chinese peg is the source of much of what is wrong with the global economy today. Americans can not be faulted for wanting to buy cheaper goods from Asia - that is called free market choice, and not lack of savings as some less informed economists would suggest. China's peg pulls manufacturing away from others (Brazil, Korea, Taiwan, Europe, USA and the list goes on). What was China's responce to the credit crisis? thats right, to build more factories... It is my guess that should China's currency float to its natural level, something like 50% of all production there would have to be made redundant... Jobs would fly back to where they came from and the 'global imbalances' that Central bankers keep going on about would just magically disappear... no need for additional regulatory bodies, oversight committees, taxes, government largesse (hey, maybe that is why no politician is doing anything about it!!)... I have always thought that IT departments should be measured on how few problems they need to solve... everywhere I have ever worked they have been measured on how many problems they need to solve... surely they can just invent their own net worth within the organisation by designing crappy systems? Maybe that is what is going on with 'global imbalances'.. maybe it is just an excuse to enlarge government... certainly would fit a socialist agenda (UK, Europe, Canada, China, Russia, and most recently USA)

Nov 16 07:08 AM

[User 373847:]

Your point about the trade imbalance between Japan and the U.S. not changing when the yen was rebalanced to the dollar misses some very important points. Many of the things the Japanese wanted to buy from America, such as cars, (yes cars), and motorcycles, were rendered unavailable due to trade barriers. At the same time the exchange rate was reset, there was huge demand in Japan for Harley Davidson motorcycles. They were outlawed. No bike with an engine larger than 750cc was allowed on their roads. How many Harleys were they likely to sell once it became illegal to ride them on the road? There was also huge demand for American muscle cars and big luxury cars. They made a law forbidding any V-8 engined cars on their roads too, saying they were too big, too fast, and too powerful. That gutted the biggest demand for American goods in Japan. When we offered V-6 engined cars, they weren't allowed to be sold at any existing dealers, and Every Single Car had to be Individually inspected before it could leave the dock, thereby raising the price and reinstalling the trade barriers.

They just switched from currency manipulated economic barriers to practical and legal barriers.

It is exactly the same in China now. They can sell virtually whatever they want here, but for us to sell a car in china, they have to be built in china and a chinese manufacturer must be partnered with the American company. That gives them half ownership for free, access to all technology, profits, just for access to their market.

Nov 16 07:54 AM

[marduk:]

This is very true...


On Nov 16 07:54 AM User 373847 wrote:

> Your point about the trade imbalance between Japan and the U.S. not
> changing when the yen was rebalanced to the dollar misses some very
> important points. Many of the things the Japanese wanted to buy from ....

Nov 16 08:02 AM

[Shaftsinker:]

I still think the exchange rate needs to be unpegged before any of the changes you're talking about are even considered.

Opening up Chinese markets is useless unless their consumers have a currency strong enough to buy exports from the West.

Nov 16 08:04 AM

[Patrick Cho...:]

You're making my point for me. I couldn't agree more.

On Nov 16 07:54 AM User 373847 wrote:

> Your point about the trade imbalance between Japan and the U.S. not
> changing when the yen was rebalanced to the dollar misses some very
> important points. Many of the things the Japanese wanted to buy from
> America, such as cars, (yes cars), and motorcycles, were rendered
> unavailable due to trade barriers. At the same time the exchange
> rate was reset, there was huge demand in Japan for Harley Davidson
> motorcycles. They were outlawed. No bike with an engine larger than
> 750cc was allowed on their roads. How many Harleys were they likely
> to sell once it became illegal to ride them on the road? There was
> also huge demand for American muscle cars and big luxury cars. They
> made a law forbidding any V-8 engined cars on their roads too, saying
> they were too big, too fast, and too powerful. That gutted the biggest
> demand for American goods in Japan. When we offered V-6 engined cars,
> they weren't allowed to be sold at any existing dealers, and Every
> Single Car had to be Individually inspected before it could leave
> the dock, thereby raising the price and reinstalling the trade barriers.
>
>
> They just switched from currency manipulated economic barriers to
> practical and legal barriers.
>
> It is exactly the same in China now. They can sell virtually whatever
> they want here, but for us to sell a car in china, they have to be
> built in china and a chinese manufacturer must be partnered with
> the American company. That gives them half ownership for free, access
> to all technology, profits, just for access to their market.

Nov 16 08:10 AM

[tunaman4u2:]

Love this article...

Again, middle class will get killed paying more for Chinese goods, having savings rate at 0%, inflating away their savings faster than wages appreciate

Question... will crushing the USD really work to fix US economy or will law of unintended consequences come to play?

Nov 16 08:30 AM

[Tetrapod:]

Thanks for the article.
I agree that the currency peg isn't everything, but I think removing it is a pre-requisite to any healing of the world's economic system, especially that of the US.
China values jobs over wealth, and thus far, the US has been willing to allow China to steal our core manufacturing jobs using their artificially suppressed Yuan.
I think that our two governments are currently engaged in a big game of Chicken (see seekingalpha.com/user/...). The US is intentionally weakening the Dollar, to try to break China's peg. China refuses to relinquish their death-grip. Sure, a badly weakened dollar will hurt the US, but it will hurt Beijing even more, as they are forced to buy more and more weakening dollars to keep their currency artificially low. The ones who are getting hurt the most are Europe and Japan, as their currencies are being forced up to unsustainable levels.
Until either Washington or Beijing relent, it's going to be a very ugly, but necessary contest. I believe we have the upper hand on this one, as we can print money faster than China can buy it all, and if China dumps the dollar, it hurts them more than us.

Nov 16 08:46 AM

[tunaman4u2:]

Does it work long term for the US? Does the inflated costs of everything disproportionately require higher wages for the public that would eliminate the potential of cheap US goods?


On Nov 16 08:46 AM Tetrapod wrote:

> Thanks for the article.
> I agree that the currency peg isn't everything, but I think removing
> it is a pre-requisite to any healing of the world's economic system,
> especially that of the US.
> China values jobs over wealth, and thus far, the US has been willing
> to allow China to steal our core manufacturing jobs using their artificially
> suppressed Yuan.
> I think that our two governments are currently engaged in a big game
> of Chicken (see seekingalpha.com/user/...).
> The US is intentionally weakening the Dollar, to try to break China's
> peg. China refuses to relinquish their death-grip. Sure, a badly
> weakened dollar will hurt the US, but it will hurt Beijing even
> more, as they are forced to buy more and more weakening dollars to
> keep their currency artificially low. The ones who are getting hurt
> the most are Europe and Japan, as their currencies are being forced
> up to unsustainable levels.
> Until either Washington or Beijing relent, it's going to be a very
> ugly, but necessary contest. I believe we have the upper hand on
> this one, as we can print money faster than China can buy it all,
> and if China dumps the dollar, it hurts them more than us.

Nov 16 08:54 AM

[Glen88:]

Patrick,

That is why the only way to address this issue is by force. Balance trade by import certificates.

Nov 16 09:13 AM

[tunaman4u2:]

China can print too... It sounds stupid but if the US wants to devalue through printing... China can do the same thing

Nov 16 09:20 AM

[James Lewis:]

Tetrapod has good point. Japan produces lots of goods through its China subsidiaries so they will not be that bad off. But Europe will take a hit. Saying this Europe likes strong currency as it is good for the immense investments they have. The reason why Europe rates are going up is because the Chinese are also buying Euros.

All this being said, if the USA takes its currency a lot lower.
Europe will start kicking up a fuss and action protectionsim against China. This is the USA real plan, kill their currency - get worldwide support against China's mercantilist policies. In doing so the USA improves it trade deficit situation as europeans will buy their goods. And wins because China will carry on buying their debt allowing them to re-inflate the economy. The secret weapon here though is the USA is trying to overheat the chinese economy with low interest rates in the meantime. Sending huge hot money flows from its banking system. Their plan is to drive up asset prices, then pullout.
Hoping that the Chinese banking system will be hit as a result of real estate loans going bad.

Markte Access is key in China. But the USA is not going to get this in any large way. So for now the issue is on the currency.

Nov 16 09:39 AM

[coreopsis:]

I realize that ignorance is a state of bliss for most Yanks, but sometimes a reality check is in order.

As most people realize, Americans know nothing about history of any kind unless it's related to pennant records.

The steady upwards revaluation of the RMB vs USD, which resulted in a cumulative 21% appreciation of the RMB, ended abruptly in 2007 as the US failed to keep its side of the deal: to preserve a stable US and global economy -- in fact, the US government backed all the players that were responsible for the housing/securitization crisis.

Face the facts:

1. Chinese imports account for only some 18% of all US imports.
2. A large portion of these imported goods reflect the final point of assembly in China.
3. Some of the biggest exporters from China to the US are US, Japanese and European multinationals.

It is little wonder that the Yanks find themselves in their own private hell, toilet, or whatever. It's only surprising that it took so long. Probably because the rest of the world was fallaciously confident that there is anything operative in the US government except a policy of building the ultimate nanny society.

Nov 16 10:22 AM

[Alan Young:]

Interesting parallel between Japan and China. After Japan was forced to increase the value of the Yen, the problem wasn't solved, but the other solutions that went into gear in Japan, such as cheap credit, ended up killing the economy and leading to 20 years (and counting) of deflation. Do ya think China has this example in mind when they say they won't follow that path?

Nov 16 10:43 AM

[robert.b.fe...:]

That would be counter productive to their goal of mainaining a set equilibrium.


On Nov 16 09:20 AM tunaman4u2 wrote:

> China can print too... It sounds stupid but if the US wants to devalue
> through printing... China can do the same thing

Nov 16 10:50 AM

[waf76:]

How can China dumping the dollar possibly hurt them more than it hurts the US? Impossible. They lose say 30% of their war chest. We see commodity prices explode, higher interest rates, lower real wages, more foreclosures, under-water loans...


On Nov 16 08:46 AM Tetrapod wrote:

> Thanks for the article.
> I agree that the currency peg isn't everything, but I think removing
> it is a pre-requisite to any healing of the world's economic system,
> especially that of the US.
> China values jobs over wealth, and thus far, the US has been willing
> to allow China to steal our core manufacturing jobs using their artificially
> suppressed Yuan.
> I think that our two governments are currently engaged in a big game
> of Chicken (see seekingalpha.com/user/...). The
> US is intentionally weakening the Dollar, to try to break China's
> peg. China refuses to relinquish their death-grip. Sure, a badly
> weakened dollar will hurt the US, but it will hurt Beijing even more,
> as they are forced to buy more and more weakening dollars to keep
> their currency artificially low. The ones who are getting hurt the
> most are Europe and Japan, as their currencies are being forced up
> to unsustainable levels.
> Until either Washington or Beijing relent, it's going to be a very
> ugly, but necessary contest. I believe we have the upper hand on
> this one, as we can print money faster than China can buy it all,
> and if China dumps the dollar, it hurts them more than us.

Nov 16 11:14 AM

[user396040:]

The yuan is outrageously undervalued. My wife and I traveled in central China in 2008 and the prices were ridiculously low - a meal for 65 cents, a room in the best hotel in a middle sized city for $40, a sleeper car train trip across half of China for $18 - most American tourists stay in tourist enclaves and don't experience this but when you go to the "real" China it is obvious that the dollar is ridiculously overvalued against the yuan. Revaluation would have many benefits - increased Chinese tourism in the US, increased US exports to China, etc. On the import front, it is possible that Chinese companies would keep their prices the same in dollar terms - this would likely lead to disputes about "exchange rate dumping"(a failure to raise prices in response to a change in exchange rates) and, after a transitional period, things would sort themselves out but the net effect would definitely be a benefit to US manufacturers who compete with Chinese imports.

Nov 16 12:24 PM

[Tom E.:]

As the author hinted at, a free floating currency is not the only answer to correcting our trade imbalance.

A collective society (Asia) will use persuasion and barriers to halt imports and use subsidies to make the exports more attractive.

In an individualistic society like the US, this is less likely to happen and it is why we will always be a loser in a free trade environment.

A Warren Buffett trade certificate plan or some other form of fair trade is needed to balance things out.

Nov 16 12:43 PM

[bobbybutte:]

as a person who has become financially independent SOLELY from allocating capital let me add some things here

The buffett trade certificate woiuld be GREAT as mentioned above

But its clear that China and america will continue down the paths they been on dominating the rest of world

China has adislike for japan always has always willand asian people will NEVER buy all the worthless stuff china manufacturers and ships here

Nov 16 01:53 PM

[JeffDB:]

"...commentators like New York Times columnist Paul Krugman have argued that Obama’s top priority should be to pressure China into strengthening its currency, in order to “rebalance” the global economy. I disagree. A more flexible exchange rate – and the stronger Renminbi that would likely result – would be a step in the right direction. But it’s not a silver bullet, and would have little effect in the absence of more substantive economic reforms. In my view, the focus on currency is a huge distraction from far more pressing issues."
----------------

It seems to me as if it might be a little like a patient with cancer, diabetes, and high blood pressure.

Treating the cancer ought to be a priority, even if it wouldn't have the patient playing soccer in short order. It might be a "distraction" in the sense that it could delay treatment of some of the other issues, but is still probably the necessary first step.

I would think that getting the Chinese to let the renminbi float to its true value or at least move in the right direction in significant fashion would be more easily accomplished than eliminating the myriad other trade barriers. That after all, is part of the international trade agreements they've signed off on and is more easily monitored by the international community. Going to court to battle them on any trade barriers one by one has to be a more time consuming and complicated battle. Even were it to be accomplished it would be of more limited value if the Chinese are in effect subsidizing all of their own manufacturers and imposing a de facto tariff on all imports via an artificial exchange rate.

Nov 16 01:56 PM

[Tony Daltorio:]

The Chinese are not stupid...they see what happened when the US finally bullied Japan into 're-valuing' the yen - the Japanese economy imploded and has yet to recover.

The US did that to get rid of an economic competitor - Japan - and they want to do the same to China in the same way, but I don't think the Chinese will let the US bully them into that trap.

Nov 16 02:45 PM

[JeffDB:]

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Nov 16 03:05 PM

[rick12345:]

why didn't the US lower its currency before the financial crises so that goods would be cheaper in other parts of the world? Because it was in their best interest to keep inflation low. I doubt very much that the US would open their heart if they were the ones growing at 8 percent.

Nov 16 07:16 PM

[Ben Gee:]

Spending beyong ones means is an addiction. Giving more money to a spending addict is like giving more liquor to an alcoholic. Between 2005 and 2008, when the yuan appreciated by 20%, US deficite went up by more than 20%, Chinese surpluses went up by more than 20%. If the US government is as much addict to negetive financing as the people, how does an appreciated yuan will help? China has a balanced trade with Japan and Germany, it has nothing to do with their currencies nor the yuan. If the US want a balance trade with China, get off its behind and find out what Japan and Germany are doing. Crying " unfair" will not make the problems go away!

Nov 17 05:53 AM

[sanjayjain:]

What if the Chinese make their currency "US Dollar". This will make its currency pegged in no uncertain terms. Think of a pegged RMB same as the Dollar.
Chinese have seen the results of the Plaza Accord. Why would they want to go for the same - unlike Japan they do not need the military umbrella Japan needed - so security that is not a trading chip.

Nov 17 10:39 AM

[Ben Gee:]

US, wake up and help yourself. China can not and will not help you, No one can help you. Stop spending beyong your means and do not use currencies as an excuse. Suck it up and get off your bud, it is definitely not too late. If the average American save 5% of income, you will have 50% of what an average Chinese make in a year. Good luck and hold up your head.

Nov 17 11:27 PM