Economics of the yen and the renminbi

Updated: Feb 2 2013, 04:32am hrs
While many argue that Chinas competitive devaluation is similar to Japans in the 1980s, the two couldnt be more different

In the 1980s, the most common threat to the economic hegemony of the United States was Japan, which was feared for its growth and the competitiveness of its industry. There was an outpouring of research evaluating the Japanese threat. The dollar was deemed too strong, and the yen and the Deutsche mark too weak. Robert Lawrences 1984 book Can America Compete was a must-read. In 1985 came the G-5 Plaza Agreement, which increased the value of the yen more than 100% in a matter of a few years. At its peak, in 1991, Japans income was 43% of US GDP. Japans growth slowed to a trickle thereafter, and starring in the mid-1990s begins the story of Japans lost decades

The situation with China could not be more different. It is very likely that the renminbi is more undervalued by an order of magnitude than at the peak of the undervaluation of the yen or the Deutsche mark in the 1980s. Chinas current account surplus is also significantly higher than that of either Germany or Japan at the peak of their respective experiments with mercantilism. Most important, Chinas growth rate, relative to its own trend, is also significantly higher. Indeed, China hit its peak growth rate just a few years ago. In comparison with an average overvaluation of the yen by 9% during 1976-85, and an average overvaluation of the Deutsche mark by 20% during the same years, China has had an average undervaluation of 41% during the last 10 years

Dj vu

It is likely that Japans growth rate collapsed in part because of the Plaza Agreement of 1985, which in three short years catapulted the yen from an average exchange rate of 240 yen to double that level (in real terms; the nominal exchange rate was cut in half). Will a quick revaluation of the renminbi lead to a similar implosion in Chinas growth And can the world afford to lose its major growth engine in the face of slow growth in the advanced economies

Interestingly, according to my measure, the yen was not really so under-valued at the time of the Plaza Agreement in 1985. It was undervalued by only 4.7% compared to an undervaluation of 31% before the dollar float in 1971 (when the exchange rate was 360 yen to $1). This result is controversial, but it is supported by the evidence presented by Jeffrey Sachs (1981) and Robert Lawrence (1987), and by other prevailing estimates of undervaluation.

The comparison between Japan in the 1980s and China today has nearly all the attributes of a perfect natural experiment. Some sense of the similarities and differences can be gleaned from a comparison of five-year periods preceding the respective crisis years of 1985 and 2007. Japan (1981-85) and China (2002-06) provide a test for several hypotheses: Both are large, export-oriented economies, both are Asian, both have high savings rates, both are alleged to have undervalued currencies, both are accumulating reserves, and both are accused of engaging in currency manipulation. There is another obvious comparison: Both are causing the United States to have correspondingly large current account deficits. In 1984, the US current account had moved to a historically high deficit of 2.4% of GDP from near balance for most of the preceding decade. And in 1998, US current account deficits started moving much higher after staying at comfortable 1-2% levels during most of the 1990s. In both 2005 and 2006, the US current account deficit reached 6% of GDP

Currency misalignment

The starting positions for the two countries are very, very different. In 1981, the yen was overvalued by 15%; in 2002, the renminbi was undervalued by 31%. The yen stayed overvalued except for the years between 1982 and 1985, and during these exception years it was undervalued by no more than 6%. In striking contrast, the renminbi has been continuously undervalued since 1994, and was undervalued by 31% in 2002, by 45% in 2006, and has been outside the extreme 25% band for the last 10 yearsthe same time that the US current account balance began to sharply deteriorate...

Current account surplus

Japans current account surplus averaged just 1.9% of GDP, in contrast to 5.0% for China. In subsequent years (after 2005), Chinas current account surplus significantly increased; the surplus (as a fraction of GDP) averaged over 10% during 2006-08. The surplus number is large for any non-oil-exporting economy and certainly for the worlds second largest economy in PPP terms. When Singapore, Taiwan, Korea, or even Japan pursued a policy of currency undervaluation, the world could absorb the repercussions without significant disruption or imbalances. But when a country with more than one-fifth of the worlds population practises a beggar-thy-neighbour policy, it can cause other economies to have substantially lower growth than they would otherwise.

Reserve accumulation

The accumulation of foreign reserves by both Japan and China seems excessive, but more so for China. Chinas reserves averaged $646 billion a year between 2002 and 2006, a level some 31 times the mean. In comparison, Japans reserves, at $21 billion, were only about 4.5 times the average for all countries during 1981-85. During its peak year, Japans reserves accounted for 2 months of imports; Chinas reserves were adequate to cover more than 15 months of imports.


Undervaluation and current account surpluses are often associated with mercantilism, but there are enough exceptions to suggest that evaluation of mercantilism (currency manipulation) is not straightforward. Between 1981 and 1985, both Germany and Japan were among the top 15 mercantilist countries. Despite having peak current account surpluses today, both countries have a low mercantilism ranking for the period 2002-06. Indias mercantilism ranking for the two periods is 64 and 34. Chinas ranking in 1981-85 is 59 and in 2002-06 is 11. In later years China moves toward even higher levels of mercantilism.

China is different

Overall, with all the data examinedexport growth, GDP growth, current account surpluses, mercantilism indices, historical tendenciesthere is only one conclusion to be drawn: The Chinese renminbi is much more undervalued today than the yen was in 1985 at the time of the Plaza Agreement. In 1985, the yen was undervalued by only 5%; in 2011, and for seven previous years, the renminbi has been undervalued by more than 40%. If the initial conditions of China and Japan are to be compared, then the beginning of the Chinese appreciation, from a level of 6.6 yuan to $1 in 2011, is comparable to a value of 335 yen to $1 in 1985. But the cheapest yen exchange rate in nominal terms was 360 yen to $1, a level that prevailed from the end of World War II until 1970. Stated differently, an exchange rate equivalent to the yen in 1985 would be 4.71 yuan to $1 in 2011. It is unlikely that anyone would have objected to the Plaza Agreement if the exchange rate was 335 yen to $1. Or that if the world considered the yen to be too cheap at a rate of 239 yen to $1 in 1985, it should consider 4.71 yuan to $1 to be too cheap in 2011. Therefore, the existing rate of 6.6 yuan to $1 can be considered a generous gift from the world to China.

The above analysis suggests that the view that China is in a similar position to Japan in the mid-1980s is misplaced and inappropriate. In the main, there are two reasons. First, the initial conditions are immensely different. Japanese GDP growth at the time of its currency appreciation was sharply lower than its own historical average and lower than the average level of Chinese growth in the 2000s. Second, real deflation and slower growth in Japan started in the late 1980s, when the yen became overvalued by more than 35%, far beyond the range of tolerance. For China to feel the same overvaluation pressure on growth, the renminbi would have to appreciate to less than 3 yuan to $1 over the next decade, an unlikely event. Even if the nominal appreciation is a gradual 10% per year over the next 10 years, as now appears possible, the renminbi will still be about 25-30% undervalued after a decade, in 2021. The point simply is that Chinas rate of currency appreciation has to be significantly faster due to Balassa-Samuelson productivity considerationsthat is, faster by 5-7% per year to make any dent in its deeply undervalued status.

Extracted from Devaluing to Prosperity by Surjit S Bhalla Oxford, 2013