Global Scapegoat: Why China Should Not Revalue Its Currency

Stephen Roach (Chief Economist, Morgan Stanley, New York)

(This article originally appeared in the July 18, 2003 issue of South China Morning Post in Hong Kong and is reproduced here with permission from the publisher)

A persistently weak global economy is now moving into a dangerous place - the blame game. World opinion is becoming increasingly united in putting pressure on mainland China to revalue its currency. In my view, that would be a serious mistake. The world has got the China story dead wrong.

The blaming of China goes something like this: with real gross domestic product growth currently hovering near 1.5 per cent in the industrial world, the ongoing vigour of the Chinese economy obviously sticks out - industrial output was up an astonishing 16.9 per cent in June, compared to June last year, and exports surged by 32.6 per cent. Mainland China is capturing market share in an otherwise sluggish world.

The problem is China's currency peg, goes the common complaint. Tied to the US dollar, it has been given a competitive boost by the greenback's recent depreciation. And if I am right and the dollar has a good deal further to go on the downside - perhaps by as much as 20 per cent over the next couple of years - then most believe that China's current competitive advantage will become all the more powerful. In this context, the world is nearly unanimous in demanding that China revalue the yuan to relieve a growing source of global tension.

I was in China last week, and this issue came up at every meeting. The Chinese are acutely sensitive to global opinion and are concerned at this shift in world sentiment. Although Chinese officials remain unwavering in their commitment to the yuan peg, I was asked repeatedly for my thoughts on how to handle this delicate issue. I urged them to leave their yuan policy unchanged, for the following three reasons.

First and foremost, there is an enormous confusion over the character of the so-called Chinese export threat. The world has formed an erroneous perception that newly emerging Chinese companies are capturing global market share with reckless abandon. In fact, the real export dynamic in China comes far more from the conscious outsourcing strategies of Western multinationals than from the rapid growth of indigenous Chinese companies. In fact, China's increasingly powerful export machine has the stamp of America, Europe and Japan written all over it.

That has been true over most of the past decade. From 1994 to the middle of this year, China's exports tripled from US$121.0 billion to US$365.4 billion. It turns out that "foreign-invested enterprises" - Chinese subsidiaries of global multinationals and joint ventures with industrial-world partners - accounted for fully 65 per cent of the cumulative increase in total Chinese exports over that period.

This is hardly an example of China grabbing market share from the rest of the world. Instead, it is more a by-product of the search for competitive survival by high-cost producers in the industrial world. Last year, a record US$52.7 billion of foreign direct investment flowed into China - making the country the largest recipient of such investment in the world. This inflow was entirely voluntary. A high-cost industrial world has made a conscious decision that it needs a Chinese-based outsourcing platform for its own competitive survival. Dismantling the yuan peg would destabilise the very supply chain that has become so integral to new globalised production models. It would be a serious negative for Japan, the US and Europe - those economies that have led the way in the rush to Chinese outsourcing. By putting pressure on China to change its currency regime, the industrial world is working at crossed-purposes - in effect, squandering the fruits of its own efforts. Fear of the so-called China threat completely misses this critical point: the power of the Chinese export machine is more traceable to "us" than it is to "them".

A second argument in support of China's currency peg is the nature of the nation's competitive prowess. Contrary to widespread perception, China does not compete on the basis of an undervalued currency. It competes mainly in terms of labour costs, technology, quality control, infrastructure, the improved human capital of its workforce and a passion and commitment to reform. I believe that if China were to revalue the yuan upward by 10 per cent - a change I do not expect or advise - its exports would suffer a minimal loss of market share.

Third, it is important to stress that there is really no doubt over the end game. China has consistently reiterated its long-term commitment to opening its capital account and making its currency fully convertible. At the same time, China knows full well that a good deal of heavy lifting on the reform front has to occur before these objectives can be accomplished. That is true of capital market reforms and of the need to clean up its banking problems. China is making extraordinary progress on both fronts, but a lot more needs to be done. Until there is greater progress on the road to financial reforms, it would be entirely premature and risky for China to float its currency. That is a critical lesson of the Asian financial crisis of 1997-1998 that an impatient world should remember when putting pressure on China. I fear there is a deeper meaning to the pressures now being put on China: unwilling to accept responsibility for their own shortcomings, the wealthy economies of the industrial world are now making China a scapegoat for their weak recoveries. That is especially true in Japan, which has led the way in China-bashing over the past year. Senior Japanese officials have repeatedly blamed China for exporting deflation and for the "hollowing out" of the Japanese labour market. Nothing could be further from the truth. Low-cost, high-quality Chinese imports provide a windfall to the purchasing power of beleaguered Japanese consumers - precisely the same type of benefits that Japan's export machine provided the world in the 1970s and 1980s.

Moreover, as I travel through the newly industrialised "special economic incentive zones" in China, I am repeatedly struck by the widespread presence of Japanese firms. Corporate Japan is not being forced to shift its production to China. This is the rational response of uncompetitive, high-cost Japanese producers attempting to maintain their share in an increasingly open global economy.

I am also concerned about the China-bashing in the United States these days. Many have noted that America's largest trade deficit is now with China - a US$103 billion shortfall last year, and on track to exceed that amount this year. Like it or not, trade deficits should not come as a surprise for a savings-short US economy. They are part and parcel of America's increasing need to import surplus foreign savings in order to finance economic growth. The only way to get that capital is for the US to run massive current-account and trade deficits.

I continue to believe that China is the world's greatest development story of the 21st century. Its emergence will not only benefit the 20 per cent of the world that lives in its most populous nation but it will also benefit the 80 per cent of us who do not. Periods of economic distress often produce scapegoats. China is at risk of becoming a scapegoat in today's increasingly dysfunctional global economy. It is high time for an increasingly inward-looking world to look in the mirror and put this dangerous blame game to an end.