A year ago this week, China announced a major change in its exchange rate policy. After holding the yuan-dollar exchange rate fixed for almost two years during the global crisis, the country’s central bank, the People’s Bank of China (PBoC), announced that the yuan would once again be allowed to float, albeit in a highly controlled way. The yuan began appreciating against the dollar immediately, touching off intense speculation about how far it would be allowed to move. A year later, what has happened?
The yuan-dollar exchange rate is a highly sensitive issue in both countries. Many politicians and pundits in the United States blame China for high U.S. unemployment, a slow recovery from the Great Recession, and a persistent trade deficit. The economics profession is a little more reserved. Many economists point out that a stronger yuan would not necessarily work magic for the U.S. economy. An appreciation of the yuan alone could simply lead to re-sourcing of imports, buying them from Vietnam, Bangladesh, India or elsewhere, in which case there would be no automatic closing of the U.S. trade gap. Still, econometric studies by and large have supported the notion that the yuan had been undervalued relative to the dollar, probably by 20 to 40 percent, at the time China’s policy shift was announced.
Exchange rates are, if anything, an even more sensitive issue in China. On the one side are China’s export industries, which are thought to wield considerable political clout. They are unambiguously interested in keeping the yuan weak in order to keep export orders flowing in. On the other side are proponents of a general rebalancing of China’s economy toward domestic consumption. China now has a lower share of consumption in GDP than any other country, with correspondingly large investment and export sectors. Many observers, both in China and abroad, consider the situation unsustainable. The export sector is vulnerable to external shocks. The productivity of investment is low at the margin, and questionable investment projects put the banking system at risk. Also, the low level of consumption, along with a highly unequal distribution of income, are sources of potential political unrest.
In addition, a weak yuan is fueling inflation in China. First, there is a direct effect. A weak yuan means high prices for imported goods, including food and other commodities, whose relative prices are rising on world markets. Appreciation would quickly take the edge off inflation of import prices. Second, holding the exchange rate below its equilibrium level requires constant intervention by the PBoC, carried out by buying excess dollars in exchange for newly issued yuan. The resulting increase in the money supply further fuels domestic inflation. In part, the monetary effect of exchange rate intervention can be sterilized through sales of POoC bills and other actions, but there are limits to sterilization, as well. (See this earlier post for more details on the relation of foreign exchange intervention to inflation.)
Against this background, then, what has actually happened to the yuan over the past year? No single number gives the whole answer. Here is a brief scorecard, showing that more has happened by some measures than by others.
- The most publicized number is the nominal bilateral rate against the dollar. During the 2008-2010 fixed-rate episode, the yuan had been held at about 6.82 per dollar. As of today, it has fallen to 6.47, an appreciation of just over 5 percent. That is more than the 2 to 3 percent that many observers considered likely when the policy shift first occurred, although not nearly enough to satisfy some U.S. politicians. However, the nominal bilateral exchange rate is the least economically significant of several measures.
- More significant is the real bilateral rate, adjusted for inflation in both countries. The simplest way to make the adjustment is to add the difference between Chinese and U.S. inflation to the rate of nominal depreciation. A higher rate of inflation in China than in the United States makes Chinese exports less competitive. Last fall, the inflation differential, measured by the CPI, was running nearly 4 percent. Since then, China’s inflation has accelerated to 5.5 percent, but U.S. inflation has increased, too. It appears that by the time June data comes in, year-on-year CPI inflation may be only about 2 percentage points higher in China than in the United States. That suggests a CPI-deflated rate of real appreciation for the yuan of about 7 to 7.5 percent, somewhat less than seemed likely six months ago.
- While U.S. policy makers focus on bilateral rates, multilateral rates are more important for China. As it turns out, about half of the change in the bilateral rate, both real and nominal, has come from depreciation of the dollar relative to other currencies. The broadest measure of the strength of the yuan is the real effective exchange rate (REER), which is an index of real bilateral rates for all trading partners, weighted by each country’s share of total trade. According to the broad REER measure published by the Bureau of International Settlements, the yuan appreciated by just 2.5 percent from June 2010 to April 2011, so it is unlikely that the figure for the full year will come in over 3 percent. That figure must be a considerable disappointment for those Chinese economists who back a general rebalancing away from exports and toward domestic consumption, and also for the central bank, which would like to get some help from the exchange rate in its fight against inflation.
- The final item on the scorecard, in many ways the most important, is the real exchange rate as deflated not by consumer prices, but by unit labor costs. Unit labor costs measure the cost of producing goods taking into account both increases in wages, which tend to raise costs, and increases in productivity, which tend to lower them. If a country’s unit labor costs rise relative to those of its trading partners, its exports become less competitive, equivalent to a real appreciation of the currency. In the United States, the unit labor cost series published by the Bureau of Labor Statistics has fallen over the past year by about 4 percent because strong productivity growth has outpaced stagnant nominal wages. China does not publish a comparable series, but there are strong indications that its unit labor costs are rising. Wage settlements with individual employers in export industries and minimum wage increases announced for important manufacturing centers have been rising at rates far in excess of inflation, often 10 to 20 percent. Productivity is presumably rising, too, but surely not that rapidly. A conservative, back-of-the-envelope guess for the rate of increase of Chinese unit labor costs would be about 5 percent per year. It could be more. If so, that would suggest a ULC-deflated rate of real appreciation of about 14 percent per year bilaterally against the dollar. The ULC-deflated Chinese REER is presumably also appreciating significantly faster than the BIS figure of 3 percent or so.
Looking at the scorecard as a whole, what conclusions can be drawn regarding the major policy issues, from both the Chinese and the U.S. points of view?
For the United States, the picture looks quite a bit brighter when viewed in terms of real exchange rates than it does in terms of the bilateral nominal rate. At the 14 percent annual rate of increase of the ULC-deflated bilateral rate, China’s imports would be losing competitiveness rapidly enough to completely wipe out the supposed 20 to 40 percent undervaluation of the yuan in just two to three years. That is good news for the growth of U.S. manufacturing industry and the U.S. job market, although not necessarily for U.S. consumers.
For China, the picture is more ambiguous. Although it is hard to come up with a solid number for the ULC-weighted Chinese REER, the rate of change is almost certainly substantial, and that is the number that matters for rebalancing. On the other hand, the continuing acceleration of consumer price inflation, and the even more rapid increase of nominal wages, suggest that the PBoC is, so far, losing the policy debate. In order to get any real help in the fight against domestic inflation, it would have to get the green light to allow a much more rapid appreciation of the nominal exchange rate. Some people think that is about to happen. Stay tuned.