News Reporters and Politicians Will Never

Be Economists: China’s Devaluation

By: Ryan Pitylak

09/29/2005

Introduction

It is commonly argued by protectionist politicians in Washington that the main cause of the U.S. trade deficit is that the Chinese yuan is undervalued.  This argument ignores not only basic economic policy, but also logical reasoning based solely on statistics available from the U.S. Census Bureau, and the Bureau of Economic Analysis.  The figures should speak for themselves.  As of 2004, the United States’ trade deficit with China only accounts for 26% of the total annual trade deficit (see table 1).  If China devalues the yuan, it will have a limited effect on the overall trade deficit.  Obviously, the appropriate revaluation of the yuan would have a positive effect on net United States exports, but it would not be sizeable enough to resolve the United States’ trade deficit problem (Michael Funke and Jörg Rahn (2005)). ¹

Valuation of the Yuan

foreign reserves by the Central Bank of China.  In 1996 the yuan became undervalued according to the data of the Behavioural Equilibrium Exchange Rate (BEER). ²  According to the BEER, the peak undervaluation exceeded 15%, as can been deduced from Figure 7.  Other data, such as the Permanent Equilibrium Exchange Rate or the Purchasing Power Parity report the yuan as undervalued as well. ³  In 2005, China changed to a managed floating exchange-rate.  This revaluation was a step in the right direction, but it is still undervalued because it appreciated the yuan only 2.1%.  However, even though the yuan is undervalued, it is not the main cause of the U.S. trade deficit.  A revaluation of the yuan would be appropriate, but this will not solve the larger U.S. trade deficit problem.  (Funke and Rahn (2005))

Net Exports

When a local currency appreciates, several factors affect the price of exports.  One factor is the relative amount of labor and capital required to make each exported good (Eswar Prasad, Thomas Rumbaugh, and Qing Wang (2005)).  If labor is a large factor of production, an appreciation will increase export prices in the short-term.  However, in the long-run, competitively priced labor is available from the China’s rural inland that could be utilized to keep wages competitively low, which would bring the prices of exports down (Funke and Rahn (2005)).  Additionally, the prices of imported intermediate inputs will be lower after the appreciation, which will make the cost of production lower.  Technology transfer or technology creation occurs because of new pressure on the prices of exports, which will increase the productivity of inputs.  

The United States total public debt has significantly increased from current account deficits, commonly referred to as trade deficits, and a government budget deficits, which have occurred almost each year since 2001. These combined deficits are commonly referred to as twin deficits. (Michael Mussa (2005)) The current account deficit was $624B in the year of 2004.  In the year of 2000 there was a government budget surplus of $255B.  In contrast, in the year of 2004 there was a government budget deficit of $401B.  Detailed data from 2001 to 2004 are available in Table 1.

Table 1 ($ in billions)

Source: Bureau of Economic Analysis (2005), U.S. Census Bureau (2005), Bureau of the Public Debt (2005), Financial Management Service (2005)

An argument by Marc Labonte and Gail Makinen (2004), of the Government and Finance Division of Congress, is that low interest rates were caused by a large inflow of Chinese devalued currency into the United States.  This has led in turn to higher consumption, and ultimately an increase in the demand for imports. However, China’s holdings of United States treasury securities were only 11% of the total treasury security head abroad in 2003 (Mussa (2005)).  China’s inflows could not be the main cause of the low interest rate in the United States.

Resolving the Problem

Addressing the problem of a trade deficit is complicated.  Figure 2 shows that the current account deficit has increased as a percentage of GDP, which illuminates a potential problem in the future.  Appreciation of the yuan seems like a possible solution to resolving the trade deficit, at first glance.  In theory, a reduction in the trade deficit should follow, because exports would increase.  They would be cheaper compared to the importing country’s currency.  A drastic appreciation in the value of the yuan is essentially the same thing as a depreciation of the dollar against the yuan.  The problem with implementing this policy to resolve the United States trade deficit problem is that the results will depend on: 1) the levels of imports and exports with that

Alan Greenspan addressed the House Financial Services Committee by saying: “we don't have adequate domestic savings, and we can't count indefinitely that we will be able to borrow at the rate we are borrowing from abroad, clearly our domestic savings rate is inadequate" (Federal Reserve (2005)).  According to the economist Ronald McKinnon, “the major ongoing and long-run distortion in the world’s financial system is America’s saving deficiency, large fiscal deficits by the Federal Government and meager household saving, coupled with a virtually unlimited dollar line of credit on [which] to borrow [money] from the rest of the world.”  He goes on to further state that “over the last two years, U.S. monetary policy has also been too loose with short-term interest rates well below the rate of inflation, leading to excess consumption” (McKinnon, Ronald (2005)).  This point further undermines the argument that Chinese foreign direct investment flows have been the root cause of increased imports because of higher consumption. 

An alternative plan for resolving the financial imbalance of the United States, according to the Institute for International Economics, is “sizable reductions in the US budget deficit, expansion of domestic demand in major economies outside the United States, and a gradual but substantial realignment of exchange rates” (Institute for International Economics (2005)).  This plan is not misaligned with McKinnon’s, rather it emphasizes some alternate solutions.

Conclusion

Revaluation of the yuan will not fix the United States’ trade deficit problem.  Sufficient evidence has been shown that through the use of basic economic theory, and a simple understanding of the international trade statistics, that the devaluation would not have a major impact on the trade deficit problem.  Several suggestions have been made in this paper with respect to how to resolve the problem.  These suggestions need to be examined carefully.

Footnotes

¹ The yuan is the most popular unit of the China’s yuan (RMB) currency

² The BEER is an alternative to the commonly used purchase power parity.   It is described as: “A behavioural equilibrium exchange rate involves reduced-form modeling of the exchange rate with standard cointegration techniques. The fundamentals driving the exchange rate are typically the economic factors determining internal and external equilibrium. However, the BEER does not guarantee the equilibrium. Any equilibrium exchange determined by internal and external equilibrium would necessarily involve a judgement about the sustainability of the current account rate and thus impose a normative constraint. The BEER is the datadetermined systematic component of the exchange rate in the medium and long run” (Michael Funke and Jörg Rahn (2005).

³ The Permanent Equilibrium Exchange Rate is another alternative to the purchase power parity.   It is described by stating that measuring “one way to measure equilibrium exchange rates is to remove the business cycle from the data using a Hodrick-Prescott or bandpass filter. Alternatively, we can decompose the time series into permanent and transitory components. The transitory component is characterised as having limited memory, while the permanent component is expected to have a persistent impact. The permanent component is then interpreted as a measure of equilibrium and forms the Permanent Equilibrium Exchange Rate (PEER)” (Michael Funke and Jörg Rahn (2005).

References

Abaroa, Patricia (2004), The International Investment Position of the United States at Yearend 2003, Washington D.C.: Bureau of Economic Analysis

Bureau of Economic Analysis (2005), Washington D.C.

Bureau of the Public Debt (2005), Washington D.C.

Economist (2004), New York, NY

Edwards, Sebastian (2005), IS THE U.S. CURRENT ACCOUNT DEFICIT SUSTAINABLE? AND IF NOT, HOW COSTLY IS ADJUSTMENT LIKELY TO BE?, Los Angeles, California: University of California and National Bureau of Economic Research

Eswar Prasad, Thomas Rumbaugh, and Qing Wang (2005), Putting the Cart Before the Horse? Capital Account Liberalization and Exchange Rate Flexibility in China, Washington D.C.: International Monetary Fund

Federal Reserve (2005), Washington D.C.

Financial Management Service (2005), Washington D.C.

Institute for International Economics (2005), Washington D.C.

Marc Labonte and Gail Makinen (2004), CRS Report for Congress: Changing Causes of the U.S. Trade Deficit, Washington D.C.: Government and Finance Division of Congress

McKinnon, Ronald (2005), Exchange Rate or Wage Changes in International Adjustment? Japan and China versus the United States, Stanford, California: Stanford University

Michael Mussa (2005), Sustaining Global Growth while Reducing external imbalances, Washington D.C.: Institute for International Economics

Michael Funke and Jörg Rahn (2005), Just How Undervalued is the Chinese Renminbi?, Hamburg, Germany: Hamburg University

Nguyen, Elena (2003), The International Investment Position of the United States at Yearend 2002, Washington D.C.: Bureau of Economic Analysis

U.S. Census Bureau (2005), Washington D.C.