On July 21, 2005, China loosened its grip on its exchange rate and allowed its currency, the Renminbi (RMB) to appreciate against the US dollar. The policy change was cautiously welcomed as a step in the right direction to reduce global imbalances – the uncertainty is how rapidly RMB is allowed to appreciate. Anecdotal evidence, nonetheless, suggests that the pace of appreciation is accelerating over time. Since 2005, the RMB has appreciated about 20%. Currently, the debate on RMB valuation and its role on trade imbalances is less intense than a few years ago. Has the RMB appreciation reduced China’s trade surplus? According to the standard textbook (a la simplistic) view, the appreciation of RMB should increase China’s imports, deter China’s exports, and thus, trim its trade surplus. What happened in the last three years, however, tells a different story. Figure 1, prepared by Kenneth Chow, traces out the exchange rate and trade balance between China and the US. It is quite obvious that the US trade deficit against China has similar upward trends before and after July 2005! RMB appreciation has no apparent dampening effect on trade balance. Figure 1. The Exchange Rate and Trade Balance between China and the US
Figure 2 plots China’s export to and import from the US. As expected, a strong RMB is associated with a high level of China’s imports. The surprising part is that China’s exports to the US are increasing (at a higher rate?) with a strengthening RMB. Huh, this is why the US deficit against China is widening in the last three years. Figure 2. China’s Exchange Rate, and China’s Exports to and China’s Imports from the US
It is also noted that the patterns of RMB exchange rate and China’s overall trade activities are quite similar to those of bilateral trade activities depicted in Figures 1 and 2., The appreciation of RMB does not even slow down the upward momentum of China’s trade balance. May be China’s trade balance does not depend on its exchange rate. Indeed, in the study China’s Current Account and Exchange Rate, Menzie, Eiji and I found that there is a considerable amount of uncertainty surrounds the responsiveness of trade flows to movements in the RMB exchange rate. Also, we should not expect quantitatively large RMB exchange rate effects (if they work in the right direction) on either multilateral or bilateral trade flows. If my memory serves, Ronald MacKinnon, an renowned economist in Stanford University, once said that the US appetite for foreign products rather than China’s exchange rate policy is the culprit of the US trade deficit. With less circumspection, one can look at the Japanese yen movement and the US trade deficit against Japan since, say, the 1970s. If it is the case, then exchange rate policy alone will not be sufficient to reduce China’s trade surplus. The US economic policy and the economic conditions in the rest-of-the-world could have substantial impact on the Chinese trade balance. May be the current subprime crisis and the associated economic slow-down in the US and the rest-of-the-world would substantially cut back on China’s surplus in the near future. Now, the heuristic part – if one takes the evidence presented in these Figures literally, then China should depreciate its currency to achieve a lower of trade surplus. Of course, I have egg on my face even with the softest mutter of such an idea. Nevertheless, in a world like ours, such an idea may not be worse than the other. For one thing, if RMB appreciation is not the official stance, China may not have to deal with the humongous hot money inflow and the associated economic ills experienced in the first half of 2008!
Figure A2. China’s Exchange Rate, China’s Imports, and China’s Exports