It cannot be much fun being the president of the European Central Bank these days. Or rather, it cannot be much fun being sent on missions abroad which are deemed to fail. These days Jean-Claude Trichet is in China, where he meets the top leaders of the country and tries to convince them to revalue the yuan and/or introduce a more flexible currency regime. He will go back to Frankfurt empty-handed and everyone knew that would be the result.
The Chinese yuan was until July 2005 linked tightly to the US dollar at the rate of 8.28 yuan per dollar. In July 2005 the Chinese authorities revalued the currency slightly and announced that they would in the future peg the yuan to a basket of currencies. The specific composition of the basket has been surrounded by confusion and some research seems to suggest that the yuan still moves very closely with the dollar. Nevertheless, today 28 Nov. 2007 the exchange rate stood at 7.39 yuan per dollar. Clearly, the yuan has appreciated against the dollar in nominal terms, but so have very many other currencies.
Mr. Trichet was accompanied in China by the prime minister of Luxemburg, Mr. Jean-Claude Juncker, who pressed the same point, namely that the “undervalued” yuan had undermined European competitiveness and brought about the ballooning trade deficit towards China. The EU’s trade commissioner Peter Mandelson has also been pressuring the Chinese to observe their WTO obligations and give European exporters better access to the vast Chinese market. Thus, the EU is following in the footsteps of the US administration, which within the last months has had several high-ranking officials in Beijing to lobby for a revaluation of the yuan and other Chinese measures to stem the country’s large trade surplus.
I am not convinced that there are strong economic arguments for pressing the Chinese to revalue the yuan or let it float. First, changing the nominal exchange might not have much effect in the longer term. It amounts to a nominal policy shock, and any real effects will only remain until the induced domestic adjustments have taken place. Second, it is virtually impossible to estimate the “equilibrium level” of an exchange rate. The only thing which is clear is that the trade balance cannot be used a measure of disequilibrium in the foreign exchange market; trade deficits (or surpluses) is the result of agents’ intertemporal reallocation and can easily be an equilibrium phenomenon. Coordination of exchange rates has largely been given up within the G7 countries. Third, other countries also have very large surpluses on their foreign trade balance. This is the case for many oil exporting countries, but also for some non-oil exporting countries. In particular, Germany has a trade surplus which in dollar terms is comparable to the Chinese. If mercantilist arguments can be used against one country, why should they not be used against other countries in a similar situation? Fourth, it is not evident that the West would be better off if the Chinese decide to let the yuan float. In that case the yuan would likely fluctuate substantially as is already the case of the dollar, euro and yen. This would imply large swings in the price of the many consumer products imported from China and may complicate the conduct of monetary policy in Europe and possibly also the US.
I am convinced that Western lecturing on economics will fall on a hard place in China. A few years ago, Western investment banks, governments and international institutions all agreed that the Chinese financial sector was in a miserable condition and that it was only a question of time before it would collapse. The main culprits were the many risky loans and complex financial interdependencies. There was no lack of advice of measures the Chinese authorities could and should undertake. It is quite ironic that a few years later it is the European and American financial institutions that are under great strain because of excessively risky lending and complex interlinked financial markets. Instead, Chinese banks are seeking overseas acquisitions and one Chinese bank has already bought part of the British bank Barclay, and another is rumoured to consider to take a stake in the American investment bank Bear Sterns.
The Chinese authorities know all this and will therefore pretend to listen carefully to all the Western visitors, but will pursue their own policies. China will eventually let the yuan appreciate, but only gradually and always with an eye on the country’s external competitiveness; after all, China still has more than half a billion very poor people and many more that are not far from poverty. Meanwhile, Europe should seek to implement internal measures seeking to improve its productivity and competitiveness with the aim of remaining an attractive trading partner for China. I wish Mr. Trichet a safe journey home from China.