Yuan Debate - Exposing the Myths

William Overholt (Asia Policy Chair, Rand Corporation)

(This article originally appeared in the November 17, 2003 issue of South China Morning Post in Hong Kong and is reproduced here with permission from the publisher)

An international obsession with the Chinese currency appears to be deflating. This passion began with Japanese accusations that China's undervalued currency was causing its deflation, continued with Europeans blaming it for slow European Union growth, hit full power with a vast US National Association of Manufacturers' campaign blaming it for job losses, and reached its pinnacle when Michigan's governor, Jennifer Granholm, declared she would back a presidential candidate based solely on the issue.

Then reality set in - well, a little bit. Last month, the Japanese, who started the whole thing, refused to back US President George W. Bush's pressure on China. On October 30, the Bush administration admitted that China was not violating rules against currency manipulation. The Federal Reserve Bank has, likewise, published research showing that China is not primarily responsible for US job losses. This latest round of anti-China obsession is now understood to have been rooted in 12 myths.

Myth one: China established its fixed-rate system to undervalue its currency in order to promote exports, thus infringing international prohibitions against manipulating the currency in one direction to create a disguised export subsidy. In reality, when China established its fixed-rate system in 1994, it overvalued the currency, compared with market rates from 1994 through to early last year, as shown by black-market rates and capital flight. From 1997 to 1999, US and other world leaders praised China for resisting market pressures to devalue. Thus, China's fixed rate has overvalued the currency for more than seven years, hurting exports, and undervalued it for less than two years.

Myth two: The Chinese currency is a principal cause of the loss of 2.7 million manufacturing jobs in the US. As Charles Wolf, of the Rand Corporation, has pointed out, when productivity grows faster than gross domestic product, and during recessions, jobs decline. The difference between productivity and growth is such a powerful cause of job losses, without Chinese influence, that there is a mystery why more jobs have not been lost. Many assume that, as manufacturing jobs in the US decline, manufacturing jobs in China rise. In fact, rising productivity leading to the loss of manufacturing jobs is much more powerful in China than in the US. Depending on which figures one uses, the decline of manufacturing jobs in China may be more than 10 times the American loss. All calculations show that Chinese manufacturing job losses are proportionately more severe than in the US.

Myth three: The rise of the service sector at the expense of the manufacturing sector means that Americans are being forced out of high-paying manufacturing jobs and into low-paying service jobs. The reality is that while some workers lose steel jobs and move to McDonald's, the larger trend is higher-paying service-sector jobs squeezing out lower-paid manufacturing jobs.

Myth four: Restricting imports from China would reduce US unemployment. In reality, over recent decades, more protectionist economies like France and Germany have experienced a negligible increase in total jobs, while the more open US has experienced a huge rise in total jobs and achieved unemployment levels about half those of France and Germany. Restricting imports would make America's economy behave like that of France.

Myth five: America faces a manufacturing crisis, caused by competition from China. The reality is that US manufacturing production has soared, decade after decade. Imports from China equal only 5 per cent of US manufacturing.

Myth sixth: Due to its undervalued currency, China is taking over manufacturing of almost everything. In reality, China's successes have been concentrated in low-end manufacturing.

Where China has tried to move quickly into higher-level exports, as in Shanghai, huge investments have resulted in slower export growth than elsewhere in China. About 83 per cent of Chinese technology exports are the exports of foreign companies, and the bulk of the profits typically go to those companies. China's hi-tech imports greatly exceed its hi-tech exports.

Myth seven: If China's currency were revalued by, say, 20 per cent, there would be a dramatic decline of its exports to the US. In reality, the impact would be quite limited because most Chinese exports rely heavily on imported parts. While international financial institutions have not completed research on the import content of Chinese exports, their best guess is that the average Chinese export is made up of 75 per cent imported parts. Therefore, a 20 per cent revaluation of China's currency would result only in a trivial 5 per cent rise in export prices.

Myth eight: China runs a massive surplus, which shows its currency is undervalued. In reality, while China runs a large trade surplus with the US, its global current-account surplus is quite small and may be vanishing completely.

Myth nine: Like old Japan, China's superior growth comes from pushing exports. In reality, in recent years, net exports have contributed negligibly, and in some years negatively, to China's growth. Domestic housing, cars, retail sales and infrastructure investments keep the economy booming.

Myth 10: Because of its undervalued currency, China is exporting deflation to the world - a principal Japanese complaint. In reality, because China kept its currency overvalued during and immediately after the Asian financial crisis, when its competitors devalued by huge amounts (for example, Thailand and the Philippines by 50 per cent), China experienced deflationary pressure from abroad, worsening its problems, as it shifted 60 million people out of state enterprises. Cheap Chinese goods could not have affected Japanese deflation by more than 0.1 to 0.2 percentage points out of 3.5 points last year.

Myth 11: Economists agree that China's currency is overvalued. In reality, the currency is under upward pressure as long as capital is allowed to flow in, but Chinese are mostly prohibited from sending money out. If all controls were freed, as foreign critics demand, some of the almost US$2 trillion now deposited in insolvent Chinese banks and earning negligible interest would flow overseas, leading to devaluation. The message to beleaguered manufacturers is: be careful what you wish for.

Myth 12: Proposed remedies and sanctions have been carefully designed to protect US jobs. In reality, if implemented, they would mostly just shift jobs from China to other Third World countries at the expense of US consumers. Most notably, at the top of the list of proposed remedies has been limits on surging Chinese bra imports. This would be a triumph for Latin American lobbyists, but, according to one of the largest US sellers of bras, the US does not make bras and, therefore, has no jobs at stake.