As I reported in last Thursday’s blog entry, last week the research institute associated with China’s Ministry of Finance published a report on its website arguing that China’s central bank should “actively guide” the yuan’s exchange rate and devalue the currency to about 6.93 against the US dollar. The purpose of depreciating, the report said, was to help maintain economic growth and bolster employment.
An exchange rate of 6.93 implies a depreciation of 1.5%. This is not much of a big deal and unlikely to make much of a difference in Chinese export prices, so I wonder why they would even say this except as a trial balloon. It is not just the research institute that has been making the devaluation argument. Although a number of officials have publicly called for stability in the exchange rate, within China there has been a heated debate about the country’s currency strategy, with several prominent commentators and economists arguing that China needs to devalue the yuan, by substantially more than 1.5%, so as to help Chinese manufacturers achieve greater competitiveness in the global export markets.
I think this kind of talk shows how mutually incompatible China’s two policy objectives are in the short term. First, China wants to boost domestic employment by boosting investment and helping restore manufacturing profitability. Second, China is under pressure, and this will almost certainly increase, to reduce its export of overcapacity, and China must address this pressure before it leads to worsening trade friction. These policy goals might not seem mutually contradictory on the surface, but I would argue that this is only because policymakers – and many commentators, it seems – are failing to distinguish between total demand and net demand. Global demand is contracting, so anything that China does to boost total domestic demand is good for the world, right? Not necessarily. Domestically, any increase in total demand will have positive implications for employment, but globally the world needs increases in net demand – that is, consumption minus production. Since China provides negative net demand to the world (it runs a trade surplus), what the world needs from China as global demand contracts is a reduction in the amount of negative net demand China provides. China can boost total demand by boosting manufacturing – every worker not fired is a worker able to consume more – but boosting manufacturing also boosts Chinese production. If it increases production relative to consumption, then China is actually reducing net demand, even while it is increasing total demand. That this is happening, by the way, shows up in the rising trade surplus. In that light devaluing the currency would be a mistake. Although it might make Chinese manufacturing exports seem more competitive in the near term, there are at least two sets of problems with devaluing the yuan. First, as should be very apparent, the slowdown in China’s exports is not a function of rising domestic costs but rather caused by declining global demand. With imports contracting rapidly, it is a mathematical necessity that countries like China that export excess capacity will, in the aggregate, be forced to export less. The fact that China’s exports have contracted by much less than most of its Asian trading neighbors suggests that in fact China has suffered much less than the average Asian exporter from the contraction in global demand, which makes the argument that China is losing export competitiveness hard to sustain. In that case devaluing the currency would almost certainly set off competitive devaluations. Some in China are arguing that other Asian countries are already devaluing, so by devaluing China would simply be keeping up, but this argument is a weak one. With Chinese exports declining by less than other Asian countries, and the Chinese trade surplus rising, it will be hard, as I point out above, to argue that China has lost trade competitiveness. More importantly China is the third largest economy in the world and has the largest trade surplus in the history of the world. It cannot act as if it were a Vietnam, whose economy is small enough that devaluation would only have a slightly negative impact on the global balance. China must understand the impact of its actions on the global, which necessarily must constrain its behavior. This is because with global demand contracting, any attempt by China to force more overcapacity onto a struggling world – i.e. reducing net demand even further – will require an even sharper contraction in manufacturing among its trade partners. China’s trade surplus is the measure of the amount of overcapacity, or negative net demand, it is exporting into the global economy, and January’s astonishingly high trade surplus of $39 billion, the second highest on record, caps a six month period during which China’s already record-breaking trade surpluses have surged. But with global demand contracting, any increase in China’s trade surplus requires that manufacturers in the rest of the world on average must cut production and fire workers by more than the amount implied by the global contraction in demand. This will almost certainly lead to widespread claims that China is playing unfairly. Already China is in serious trade disputes with India and Indonesia, and with protectionist sentiment on the rise in the US, Europe, and the rest of the world, this is not the time to create more protectionist fury. A devaluation of the yuan, however small, would be seen as China’s answer to the Smoot-Hawley tariff increase, the notorious bill passed by the US Congress in 1930 that put the nail in the coffin of international trade (and a great example of the US failure to understand in 1930 that, like China today, it was too big to ignore the global impact of its domestic policies). In that case devaluation would almost certainly lead to an increase in trade friction. In the 1930s, Smoot-Hawley had that very effect, and as the country with the world’s largest trade surplus in the 1920s, the US found itself, ironically, as the greatest victim of the contraction in world trade it did most to sponsor. As I have argued many times in a world of contracting demand, it is countries with excess capacity or negative net demand – the trade surplus countries – who are most vulnerable to a collapse in international trade. Even more than the US in the 1930s, China would suffer enormously from trade war.
The second set of arguments against devaluation involves a little longer term thinking, and so might easily be ignored in the panic of the crisis, but China’s economy must make the transition from export orientation to reliance on its domestic market. The process is never easy. To devalue the currency now would mean failing to take advantage of the shift that is already taking place and would push the economy in the wrong direction – that of further constraining already-too-low domestic demand, while increasing the importance of the export sector in the Chinese economy. The difficult transition from export reliance to reliance on domestic consumption is not a problem that can be evaded, and postponing it will only make the transition worse.
As counterintuitive as it may seem, I think China should actually continue revaluing the yuan, but before doing so it must reach an explicit agreement that in exchange for revaluing, its trade partners will maintain open markets for China’s exports. This is key, and on Wednesday I think I will have a piece in the Financial Times that tries to make this point very explicitly. A trade war would force China to adjust quickly, and I think that would be socially disastrous for China, and at any rate given the structure of the country’s financial system and development model it cannot make the transition quickly. As the world’s leading provider of excess capacity, China cannot avoid a difficult adjustment in a world of collapsing global demand. The goal of policymakers must be to slow the necessary adjustment over several years by negotiating an orderly decline in global trade imbalances. This requires cooperation, not devaluation. Sunday’s softer G7 communiqué which, according to an article in today’s the Financial Times, “adopted milder language than recently regarding China’s handling of its currency,” is a welcome step towards more civil discourse, but it should not mask the risk of rising protectionism. Among themselves the G7 can be as diplomatic as they like, but governments respond to domestic pressure, and nothing creates pressure like rising unemployment. Japan’s awful 2008 Q4 GDP numbers (down an astonishing 12.7% on an annualized basis) shows just how heavy that pressure will be. I am off to Washington DC later today to testify before the US-China Commission and meet a bunch of friends in Treasury and State. On Saturday I will try to write about what I hear there.