It takes two to tango, but unless both partners move in perfect cohesion, a sequence of graceful maneuvers can be reduced to a series of clumsy moves. The latter depiction seems to be particularly apt when it comes to explaining the gyrations between the Chinese yuan and the U.S. dollar, thanks to China’s recalcitrance on the topic of yuan appreciation and the United States’ reluctance to be a partner in this currency tango.
A great deal is at stake here. The contentious issue of yuan revaluation has implications not just for the world’s two largest economies and the global economy, but also for your personal well-being through its potential impact on your expenses, investments and perhaps even job prospects.
An Economic Miracle
China commenced its transition to a global powerhouse in 1978, as Deng Xiaoping ushered in sweeping economic reforms. In the three decades from 1980 to 2010, China achieved GDP growth averaging 10%, in the process lifting half of its 1.3 billion population out of poverty. The Chinese economy grew five-fold in dollar terms from 2003 to 2013, and at $9.2 trillion, it was easily the world’s second-largest economy at the end of that period.
But despite a slowing growth trajectory that saw the economy expand by “only” 7.7% in 2013, China appears to be on track to surpass the United States as the world’s largest economy sometime in the 2020s. In fact, based on purchasing power parity - which adjusts for differences in currency rates - China may pull ahead of the U.S. as early as 2016, according to a report on global long-term growth prospects released by the Organization for Economic Cooperation and Development in November 2012. (It should be noted that such bullish estimates about China’s long-term growth prospects are viewed with considerable skepticism by a growing number of economists and market watchers.)
China’s rapid growth since the 1980s has been fueled by massive exports. A significant chunk of these exports goes to the U.S., which overtook the European Union as China’s largest export market in 2012. China, in turn, was the United States’ second-largest trading partner in 2013, its third-largest export market, and by far its biggest source of imports. The tremendous expansion in economic ties between the U.S. and China - which accelerated with China’s entry into the World Trade Organization in 2001 - is evident in the more than 100-fold increase in total trade between the two nations, from $5 billion in 1981 to $559 billion in 2013.
China’s Currency Policy
A cornerstone of China’s economic policy is managing the yuan exchange rate to benefit its exports. China does not have a floating exchange rate that is determined by market forces, as is the case with most advanced economies. Instead it pegs its currency, the yuan (or renminbi), to the U.S. dollar. The yuan was pegged to the greenback at 8.28 to the dollar for more than a decade starting in 1994. It was only in July 2005, because of pressure from China’s major trading partners, that the yuan was permitted to appreciate by 2.1% against the dollar, and was also moved to a “managed float” system against a basket of major currencies that included the U.S. dollar. Over the next three years, the yuan was allowed to appreciate by about 21% to a level of 6.83 to the dollar. In July 2008, China halted the yuan’s appreciation as worldwide demand for Chinese products slumped due to the global financial crisis. In June 2010, China resumed its policy of gradually moving the yuan up, and by December 2013, the currency had cumulatively appreciated by about 12% to 6.11.
The true value of the yuan is difficult to ascertain, and although various studies over the years suggest a wide range of undervaluation - from as low as 3% to as high as 50% - the general agreement is that the currency is substantially undervalued. By keeping the yuan at artificially low levels, China makes its exports more competitive in the global marketplace. China achieves this by pegging the yuan to the U.S. dollar at a daily reference rate set by the People’s Bank of China (PBOC) and allowing the currency to fluctuate within a fixed band (set at 1% as of January 2014) on either side of the reference rate. Because the yuan would appreciate significantly against the greenback if it were allowed to float freely, China caps its rise by buying dollars and selling yuan. This relentless dollar accumulation led to China’s foreign exchange reserves growing to a record $3.82 trillion by the fourth quarter of 2013.
China views its focus on exports as one of the primary means of achieving its long-term growth objectives. This viewpoint is backed by the fact that most nations in the modern era, notably the Asian Tigers, have achieved sustained increases in per-capita incomes for their citizenry mainly through export-oriented growth.
As a result, China has consistently resisted calls for a substantial upward revision of the yuan, since such a revaluation could adversely impact exports and economic growth, which could in turn cause political instability. There is a precedent for this caution, going by Japan’s experience in the late-1980s and 1990s. The 200% appreciation in the yen against the dollar from 1985 to 1995 contributed to a prolonged deflationary period in Japan and a “lost decade” of economic growth for that nation. The yen’s steep rise was precipitated by the 1985 Plaza Accord, an agreement to depreciate the dollar to stem the surging U.S. current account deficit and massive current account surpluses in Japan and Europe in the early 1980s.
Demands in recent years by U.S. lawmakers to revalue the yuan have grown in direct proportion to the nation’s burgeoning trade deficit with China, which soared from $10 billion in 1990 to $315 billion in 2012. Critics of China’s currency policy claim that the undervalued yuan exacerbates global imbalances and costs jobs. According to a study by the Economic Policy Institute in 2011, the U.S. lost 2.7 million jobs - mainly in the manufacturing sector - between 2001(when China entered the WTO) and 2011, resulting in $37 billion in annual wage losses because these displaced skilled workers had to settle for jobs that paid much less.
Another criticism of China’s currency policy is that it hinders the emergence of a strong domestic consumer market in the nation because:
a) the low yuan encourages over-investment in China’s export manufacturing sector at the expense of the domestic market, and
b) the undervalued currency makes imports into China more expensive and out of reach for the ordinary citizen.
Implications of Yuan Revaluation
Overall, the effects of China’s currency policy are quite complex. On the one hand, the undervalued yuan is akin to an export subsidy that gives U.S. consumers access to cheap and abundant manufactured goods, thereby lowering their expenses and cost of living. As well, China recycles its huge dollar surpluses into purchases of U.S. Treasuries, which helps the U.S. government fund its budget deficits and keeps bond yields low. China was the world’s biggest holder of U.S. Treasuries as of November 2013, holding $1.317 trillion or about 23% of the total issued. On the other hand, the low yuan makes U.S. exports into China relatively expensive, which limits U.S. export growth and will therefore widen the trade deficit. As noted earlier, the undervalued yuan has also led to the permanent transfer of hundreds of thousands of manufacturing jobs out of the U.S.
A substantial and abrupt revaluation in the yuan, while unlikely, would render Chinese exports uncompetitive. Although the flood of cheap imports into the U.S. would slow down, improving its trade deficit with China, U.S. consumers would have to source many of their manufactured goods - such as computer and communications equipment, toys and games, apparel and footwear - from elsewhere. Yuan revaluation may do little to stem the exodus of U.S. manufacturing jobs, however, as these may merely move from China to other lower-cost jurisdictions.
Mitigating Factors and Glimmers of Hope
There are some mitigating factors and glimmers of hope on the issue of yuan revaluation. A number of analysts maintain that one reason for the huge increase in U.S. imports from China is due to global supply chains. Specifically, a significant proportion of these imports are from multinational companies based in China that use facilities located in the nation as the final assembly point for their products. Many of these companies have moved their production facilities from higher-cost nations such as Japan and Taiwan to China.
As well, the increase in China’s current account surplus and growth in foreign exchange reserves have slowed down appreciably in recent years. So despite the yuan appreciating by less than 4% against the dollar in 2012-13, some analysts think the currency is not as undervalued as it was previously.
The PBOC said in November 2013 that China sees no further benefit to increase its foreign currency holdings. This has been interpreted as a signal that the dollar purchases that cap the yuan’s rise may be scaled back, allowing the currency to appreciate gradually.
Finally, concerns that China may dump its holdings of U.S. Treasuries in the event of yuan revaluation seem largely overblown. The size of China’s Treasury holdings itself is an argument against sudden yuan revaluation, since an overnight 10% increase in the currency would translate into a $130 billion notional loss on China’s U.S. dollar-denominated Treasury holdings.
The Bottom Line
Little is to be gained by U.S. lawmakers trying to get the U.S. Treasury to cite China as a “currency manipulator” or by introducing bills in Congress that aim to force the pace of China’s currency reform, as these may only strengthen China’s resolve to take its own time to amend its currency policy.
Cooler heads need to prevail when addressing this burning issue, as the worst-case scenario would be an acrimonious trade war between the world’s two biggest economies. A trade war would create global financial turmoil and wreak havoc on investment portfolios, apart from reining in global economic growth and perhaps even triggering a recession.
But that scary scenario is quite unlikely, even if the rhetoric is ratcheted up by both sides. The most likely outcome going forward is one of gradual appreciation of the yuan, accompanied by measured dismantling of currency controls as China moves toward a freely convertible currency. So it may be a few years before the yuan terminates its tango with the greenback and heads out on its own.