Revalue the Yuan? Too Big a Job for One

China Economic Quarterly

Over the past two years, China has attracted much criticism for its stubborn insistence on sticking to its currency's effective peg against the US dollar. The latest variation on this theme is that floating or revaluing the yuan will solve a menacing problem in the global economy.

This can be summed up as follows. The US is acting as the buyer of last resort for the world's goods, to a greater extent than ever. As a result, it is going ever deeper into debt. The difference between what the US economy produces and the larger amount that US citizens buy - the current account deficit - has widened to about 6 per cent of gross domestic product, a very high figure.

This deficit is financed by trade-surplus countries - notably Japan, Europe and major oil producers - who use the dollars generated by their trade surpluses to buy US treasury bonds. In effect, the world's goods producers keep lending America money so that the US can keep buying their goods.

Up to a point, this system can work well for a long time. The International Monetary Fund reckons that the US could sustain a current-account deficit of about 3 per cent of GDP indefinitely. But a deficit of 6 per cent - and growing rapidly - will lead to an unsustainable debt burden in America. If not corrected, it will ultimately create a severe global recession.

The solution is straightforward. Americans must save more and spend less, and people in trade-surplus countries should do the opposite. Part of the recipe for this is a significant devaluation of the US currency against those of its major trading partners. A cheaper US dollar will discourage spending by Americans, and encourage spending elsewhere.

There is a temptation to jump to the conclusion that China is the decisive force in righting the global imbalance. After all, the US dollar has already depreciated substantially against the euro and yen over the past two years, but not at all against the yuan, thanks to the peg. Surely, if China floated its currency, all would soon be right with the world.

Yet this is not so. According to economist Jonathan Anderson at UBS Securities, the US current-account deficit will surpass US$600 billion this year. Against this, Japan, South Korea and Taiwan will post a combined surplus of about US$230 billion. Singapore and Malaysia will combine for another US$45 billion. China is heading for a surplus of about $40 billion.

These figures suggest that a joint effort is required, and that China should be a significant but by no means the chief player. This perception is reinforced by an analysis of how China has built up its huge foreign currency reserves. If it accumulated these reserves mainly by giant trade surpluses, as Japan does, then it would be fair to argue that yuan revaluation holds the key to global rebalancing. In fact, less than one quarter of China's reserve accumulation has come from the trade surplus. A far bigger factor has been short-term capital flows - in excess of US$100 billion over the past two years alone. Some come in disguised as current account transactions, creating an exaggerated view of China's effect on world trade flows and, consequently, on world currencies.

Chinese policymakers know that such inflows are highly volatile, unlike trade balances. So they are rightly sceptical of the notion that they should change their long-run currency regime simply in response to short-term capital movements.

For its own reasons, China is likely, within the next year or two, to move the yuan off the US dollar peg to a trade-weighted basket peg with a wider trading range. The goal will be to get the yuan to appreciate slowly. As a result, China's trade surpluses will shrink further, and perhaps turn into modest deficits. This shift makes sense for China's domestic economy, and it will also help redress global imbalances. But it is not a magic wand; other nations must still play their part.

(Originally appeared in the January 3, 2005 issue of South China Morning Post in Hong Kong, reproduced here with permission.)