The narrative of China?s meteoric rise in the last couple of decades appears to have been taken straight from a textbook of economics. The country had a shortage of capital but an abundant, cheap labour force. The West had capital in abundance but an expensive labour force. The logic of arbitrage and specialisation then prompted multinationals to head towards China. Their profits soared, consumers in the West got accustomed to cheaper goods imported from China and the country started prospering. Everyone connected to this process seemed happy (except workers in the West who lost jobs), until the global recession kicked in.
Now, China bashing has become a favourite pastime of the western media due to its alleged role in manipulating the renminbi (RMB). The market for foreign exchange in China is strictly controlled by official regulations and the Chinese government sells RMB and buys up dollars (and other major currencies) to keep the value of the RMB in the neighbourhood of 6.80 RMB to the dollar. To be fair, the rate was around 8.25 in 2005 and China followed the path of gradual adjustment until the rate hit its current level in the wake of the global recession in 2008. Detractors claim that an artificially weakened RMB is contributing to global imbalances because it gives Chinese exporters an undue advantage at the expense of global competitors. In the run-up to the November election to the Congress and unemployment levels hitting close to 10%, law-makers in the Democratic party have started pressurising the Obama administration to initiate steps against the Chinese policy of keeping the RMB weak through its transactions in the world currency markets.
Different studies offer different estimates of undervaluation. These range from 40% (based on the presumption that the current account balance is the sole determining factor of exchange rates) to 12% (based on the purchasing power parity argument). China?s current account surplus was $46 billion in 2003 and is expected to rise to $360 billion by the end of 2010. Many critics argue that such a phenomenal rise in trade surplus can partially be attributed to currency manipulations.
So far the Chinese authorities have resisted pressure on this front. From China?s point of view, there are several reasons that explain their reluctance to follow a market-oriented policy in the foreign exchange market. First, severe capital flight during the Asian crisis of 1997 taught many countries a lesson, leading all of them (not China alone), to accumulate large reserves of foreign exchange. Second, many Chinese officials believe that the decision to revalue the Japanese Yen, in the wake of pressure in the mid-nineties, prolonged a severe recession in the country and China does not want to repeat the mistake. Third, noted MIT political scientist, Professor Yesheng Huang, argues that it is not the appreciation of the RMB but the speed of appreciation that matters most to China. If done gradually, it will lead to a speculative bubble because investors will believe that sooner or later, the currency will appreciate again. In order to make arbitrage gains, they will invest heavily in real estate, which will generate a bubble in the property markets. This is already happening in Beijing, Shanghai, Hong Kong and other big cities and a slower adjustment in the rate of currency appreciation will make things much worse by fuelling the markets? expectation for further adjustment. On the other hand, a one shot big-bang appreciation will make the export sector vulnerable to bankruptcies and may lead to widespread unemployment in the country. The West argues that their stimulus programmes to boost aggregate demand are being undermined by an artificially low exchange rate in China because consumers in the West are buying Chinese, not domestic, goods. As a result, many countries are imposing non-tariff barriers to China?s exports and China?s complaints to WTO have increased dramatically, in spite of a 46% increase in exports to the rest of the world.
The situation thus mirrors the post depression era when the beggar-thy-neighbour policy of competitive currency devaluations and unfair trade practices delayed global recovery. The IMF and WTO were created to ease tensions between nations and to coordinate both finance and trade policies across the globe. It is time now for them to show that they have a set of teeth strong enough to bite when the parties involved in a dispute are the incumbent and would-be economic giants of the world.
The author is reader in finance at the University of Essex