Why It's Wrong to Accuse China of Manipulating Its Currency
Calla Wiemer is a visiting scholar at the UCLA Center for Chinese Studies, a research associate at the National University of Singapore East Asian Institute and a consultant to the Asian Development Bank. This op-ed was recently published in the Wall Street Journal Asia.
Published: Tuesday, February 10, 2009
Wiemer will be giving a talk on this subject Monday, April 13, for the center. For more information, go here.
China has taken a certain amount of heat from outgoing Treasury Secretary Henry Paulson for helping bring on the global financial crisis. But his newly sworn-in successor has just raised the temperature a notch. In written testimony to the Senate on Jan. 22, Timothy Geithner invoked the dreaded "currency manipulator" label intimating that China is deliberately undervaluing its currency, the yuan.
This is a heavily loaded term that the Bush administration for some years managed to dance around. Currency manipulation is prohibited under the International Monetary Fund Charter and can be taken as grounds for retaliatory trade sanctions.
The attention to the exchange rate is misplaced. A coherent story of global payments, imbalances and the financial crisis can be told without recourse to charges of an undervalued yuan. Likewise, an agenda for getting out of the crisis and setting the global economy on a more balanced path does not depend on the yuan. The policy focus should be on stimulating consumption in China. The need for that predated the financial crisis but is now magnified by it.
Both China and the U.S. pursued macroeconomic policies from 2001 to 2007 that were successful in achieving high growth with low inflation. Just how successful in China's case is only revealed when real growth figures are derived, following standard international practice, by subtracting the inflation rate from the nominal growth rate.
This approach shows that from a slowdown that bottomed out in 2000, with growth at just 2.3 percent, the pace soared to robust double digits and stayed there for seven years. The year 2001 was pivotal due to China's World Trade Organization entry, although the foundation for sustained growth had been laid in the late 1990s with state sector downsizing, housing privatization and liberalization of labor migration.
In a pattern typical of developing countries in their take-off phases, China's surging growth brought a rise in the national saving rate. What makes China's case stand out is that the saving rate started from an already high 38 percent in 2000. An inexorable climb from then onward elevated the rate to 51 percent in 2007.
A litany of factors is routinely cited for why China's saving rate is high: the need to provide for one's own retirement; the need to self-insure against risks of illness, injury or job loss; the need to meet children's education expenses; and the need to accumulate funds to support lumpy expenditures on consumer durables or business start-ups in the absence of credit markets that function to do so. Although these factors explain a high level of saving, they do not offer insight as to why the saving rate rose so dramatically during a time when, if anything, life became less precarious and the financial system became more functional.
A standard economic theory of saving – the late MIT economist Franco Modigliani's renowned "life-cycle hypothesis" – explains the rise in saving. The hypothesis holds that current income is apportioned to consumption over a lifetime. This means, first, that any income growth above the norm will be disproportionately saved in the current period to be meted out for consumption purposes in future years. Because only those in their working years benefit from faster income growth, only this segment increases its consumption while those in retirement consume based on the lower income of an earlier time.
The hypothesis implies, second, that a rising share of population in the workforce will also result in an increase in the saving rate. On both counts – unusually rapid income growth and a demographic bulge moving into working ages – China's rising saving rate is as the theory predicts. In other words, it has nothing to do with the exchange rate.
A rising saving rate has implications for China's external accounts. National saving that isn't used for domestic investment is invested abroad. To fund that capital outflow, exports must exceed imports. In China's case, a rise in saving was paralleled by a rise in domestic investment from 2000 to 2004, leaving the saving surplus and hence the trade surplus constant as a share of GDP at a modest 2.0-2.5 percent.
In 2004, fearing the economy was overheating, the Chinese government clamped down on investment spending and the saving-investment gap began to widen. With investment held in check over the next few years against a continued increase in saving, the trade surplus boomed.
On the U.S. side, the capital inflow – not just from China but from the developing world as a whole plus the oil exporting countries – had an incipient deflationary impact. Upward pressure on the dollar from the demand for U.S. assets made U.S. goods less competitive, and without countervailing action this would have caused the economy to falter. Expansionary monetary policy kept that from happening, however, as the Federal Reserve under former Treasury Secretary Alan Greenspan kept interest rates very low for a very long time. The liquidity boost from a credit expansion triggered by innovative new financial instruments also contributed. This combination fueled wealth gains that stimulated U.S. consumer demand and kept the economy going.
Both the U.S. and China thus enjoyed strong growth with low inflation for a nice, long stretch. The U.S. propagated this trend with low interest rates and financial innovation, while China propagated it with a stable exchange rate and ongoing reform of its economic system.
China is no different from most emerging market economies in adopting policies of foreign exchange market intervention, capital controls and interest rate regulation. It takes very sophisticated economic institutions to pull off liberalized foreign exchange and financial markets, and even then there are no guarantees of immunity against crisis. In the emerging market context, the exchange rate is an important macroeconomic policy lever. Currency appreciation reins in an economy that is overheating; depreciation stimulates an economy that is flagging. China's course of gradual yuan appreciation since 2005 proved effective in allowing the economy to grow at high speed while still keeping inflation in check.
China's growth, however, has relied too much on exports and not enough on domestic consumption – a problem for long term, sustainable economic growth. The remedy is to direct fiscal spending toward consumption, in particular for health care and education where China is notably lacking. Given the sagging state of external demand, strong domestic stimulus can be exercised without danger of the overheating that might call for currency appreciation as an offset.
The exchange rate, then, can stay where it is. A fiscal stimulus that succeeded in restoring consumption to the share of GDP witnessed as recently as 2003, given a maintained investment share at the 2004-07 level, would cause China's trade surplus to disappear.
Geithner, to his credit, emphasized in his written testimony the importance of consumption stimulus in China. He would do well to stick to that argument going forward and exclude further pronouncements on the exchange rate. Meanwhile, rising health care and education spending in China present the prospect of greater demand for medical equipment and educational aids.
This suggests the U.S. might do well to pursue a negotiating strategy focused on intellectual property rights and a freer market for ideas the better to exploit its comparative advantage – instead of a trade war rooted in a wrong-headed assessment of the yuan.