The Essence of the Chinese Currency Problem

Toyoo GYOHTEN (President, Institute for International Monetary Affairs)

(This article is based on an interview with Mr. Gyohten on February 4, 2004)

Exporting Deflation and Unemployment

It is inevitable that the Chinese currency issue is attracting much attention these days. So far there has predominantly been an accusation that Chinese products have unfair trade advantages due to the undervalued yuan, thus exporting deflation and reducing employment opportunities in other countries. That has been the main point of the argument made by Japan and the U.S.

Although such an argument may not be false, that is not the essence of the Chinese currency issue in my view. First, it would not be possible to replace Chinese imports such as sneakers and sweaters with home made products in Japan even if the yuan is revalued some 20 or 30 percent. Second, as for deflation, it may be true that cheap Chinese imports tend to give downward pressure on domestic prices, but one might as well maintain that mild deflation is not too problematic in the case of Japan. Thus, I would say that the typical argument referring to deflation and unemployment is missing the point.

Rather, the most serious problem is that China will suffer from tremendous internal disequilibria due to the prolonged undervaluation of its own currency. In fact, Japan has undergone the same process in the postwar period, when Japan could achieve high economic growth thanks to the undervalued exchange rate of 360 yen per dollar for a quarter century, and as a result developed its export-led economic structure. Such a situation lasted so long that Japan was stuck with large excess supply capacity, and excess borrowings, excess debts, excess employment, etc. behind it. Needless to say, that became unsustainable by the end of the 1980s, leading to the bad debt problem and the resultant fiscal deficit problem, as well as the associated public pension problem.

China's Excess Capacity and Global Risk

In short, the prolonged disequilibrium in the exchange rate has led to the distorted economic structure, resulting in Japan's "lost decade". Japan needs to warn China that it could make the same mistake. In a sense, it has already begun in China. As a matter of fact, owing to the undervalued yuan there has been massive investment in China's manufacturing industry, which has been expanding its exports by almost 40 percent a year. Although the excess supply problem has not yet surfaced due to increasing sales, its symptoms can be detected everywhere in China.

For example, China's bad debt problem has already become more serious than Japan's, and its fiscal condition is rapidly deteriorating, partly because massive public funds are being used to deal with bad debts. Because labor is supplied almost infinitely from agricultural regions, there will likely be excess employment and eventually excess consumption as well. Furthermore, China's demand for primary goods and basic materials seems excessive, posing a global risk regarding their balance with the environment.

Therefore, the essence of the Chinese currency issue is not the short-term problem that Chinese products have unfair advantage in international trade, but the longer-term problem that the Chinese economic structure will be distorted and pose a worldwide risk as a result.

Needless to say, Chinese leaders understand the nature of the problem in principle, as they are learning from Japan's experience. In reality, however, they have no choice but to say that "drastic adjustment is difficult," because they wish to avoid the financial problem and other systemic problems likely to emerge due to slowed economic growth. Therefore, they will try their best to prepare for future adjustments such as the liquidation of some state-owned enterprises and the disposition of bad loans, which may be regarded as their effort to adopt a more flexible exchange rate system for their currency.

In spite of their effort, however, China is bound to suffer from expanding disequilibria and built-in export surplus structure once such a huge production capacity is established. In this sense there is increasing instability in the world economy, and there will inevitably be a need for international cooperation and negotiations for exchange rate adjustments.

Forming an Asian Currency Basket

Finally, what Japan should do strategically under this circumstance is take up as the most urgent agenda the issue of strengthening the unifying and cooperative relationship on the financial problem within the framework of ASEAN plus three (Japan, Korea and China). For instance, the development of financial markets in less developed countries--especially bond and stock markets--should be facilitated so as to make those markets work as the unified Asian financial market. As for currency markets, we need to construct a basket of currencies as a stable benchmark for Asian currencies as soon as possible.

More concretely, a basket of currencies consisting of the yen, the Euro and the U.S. dollar should be established so that Asian currencies may be managed to have a stable relation to the value of such a currency basket. At the same time, Asian currencies, especially the Chinese yuan and the Korean won, should be made freely tradable in the markets in order to make them international currencies and include them in the currency basket. Eventually by taking the U.S. Dollar and the Euro out of the basket, we will have only Asian currencies left in the basket to make it the Asian version of the Euro. We must take the first step to that end as soon as possible. Otherwise, Asian currencies are likely to be pressured one by one for revaluation, and the dollarization of currencies would be the only way to avoid such pressure, whether or not it is preferable from the Asian point of view.