Photo Caption: An independent review panel has determined in a report send to the US Congress Wednesday that China is manipulating its currency, to the great detriment of US industry(AFP/File/Frederic J. Brown)

CHINA - Exchange rates have become a hot topic in the past few months. On the one hand, the US dollar has depreciated significantly against major currencies in the past two years. Recently it dived even deeper. Investors began to worry about its impact and if the dollar will begin a free fall. On the other, many countries accused China of undervaluing its currency by 40%, damaging the competitiveness of manufacturers who export to China. Where does the 40% figure come from? What are the economic consequences?

The US Dollar Devaluation

Since finance ministers of the G7 reached an agreement to keep “more flexible exchange rates” in September, the market interpreted this as a call for Asian counties not to manipulate the exchange rates and let the dollar fall. Consequently, the US dollar, which has already depreciated in the past years, dropped significantly against all major currencies. Is it justified? Why?

Personally I think the dollar depreciation is not accidental. The U.S. has incurred a current account deficit consecutively for the past 12 years. Last year its current account deficit amounted to $481 billion, and this year it could go up as high as $550 billion. As the current account deficit escalates, the U.S. accumulates more and more debt. In 2002, the U.S. owed the rest of the world $2.6 trillion, equivalent to 25% of its GDP. And this cannot go on forever. The G7 meeting may have triggered the correction.

On the other hand, Japan’s net international assets have increased in the past decade. In 2002, its net assets accounted for about 35% of its GDP. France and Germany also have large net international assets positions.

These are some of the forces that push the value of the US dollar down in favor of the yen and the euro. Therefore, we observe that since 2002, the dollar has depreciated against the euro by 25%, the yen 18% and the pound 15%.

The dollar depreciation is good for two reasons. The depreciation will help reduce US’s current account deficit because the dollar depreciation will lower the prices of US exports, thus increasing the competitiveness of US corporations. To some extent, recent stock appreciation has been associated with the dollar depreciation. Both are good for the US economic recovery and the world recovery as well.

The Undervaluation of Chinese Currency

The Chinese currency, renminbi has stayed pegged with the dollar for more than eight years. Recently, many countries have blamed China for undervaluing its currency by about 30-40% against the dollar. How come 30-40%? For simplicity, the figure reflects the GDP growth gap between China and the United States. Chinese exchange rate against the dollar was 8.28 yuan per dollar May 1995, and has remained at this level ever since. If we assume that the renminbi was fairly valued at that time, then the following calculation goes through. During the past eight years and half, Chinese average annual growth rate is about 7-8%, according to Chinese official statistics. During this time, the average growth rate in the US is about 3.5%. So if you multiply the difference in annual growth rates with the number of years, it is roughly 30-40%.

Why does undervaluation of the renminbi become a hot topic? This is because such an undervaluation policy has five significant impacts on income distribution and resource allocation. 1) The currency undervaluation brings about great profits to Chinese exports. How much? Let’s calculate it. Current exchange rate is 8.28. The renminbi undervaluation of 30-40% means that the fair exchange rate is between 4.97-5.80 Chinese yuan per dollar (8.28*0.6=4.97 or 8.28*0.7=5.80). That is exporters in China gain 43% to 66% in profits due to the currency undervaluation. 2) Chinese residents who consume imported goods have to pay higher prices than they should; 3) This policy is adversely affecting traders who export to China as well as manufacturers outside of China. That is part of the reason that U.S. manufacturers complain about dumping. Since the euro, pound and yen have all appreciated against the US dollar, thus the renminbi. So manufacturers in the euro zone, Britain and Japan suffer the most. 4) Funds flow to China. Foreign direct investment in China increased tremendously in the past few years. Most of those who have profited are export oriented. That is how jobs, especially manufacturing jobs are reallocated to China.

However, as funds flood to China, to maintain the exchange rate unchanged, the People’s Bank of China has to increase its money supply, which is causing the economy too hot and unbalanced development. Real estate bubble is building up in China. It is a well-known fact that non-performing loans account as high as 25% to 50% of Chinese banks’ assets. By international standard, these banks are already bankrupt. Once the real estate bubble bursts out, it will surely trigger a financial crisis, which will tremendously damage the Chinese economy. Therefore, with a pegged exchange system, the renminbi is artificially undervalued. It twists the price system and affects the long-term economic development in China.

ABOUT THE AUTHOR: Dr. Tianlun Jian has been working on the Chinese economy for over a decade. He participated in the renminbi exchange rates reform when he was with the State Administration of Foreign Exchange in Beijing. After he obtained his doctorate degree in Boston University, he worked on China’s economy in Harvard University. Dr. Jian is now an economist in an investment firm in Boston.