The dollar and the yuan

China has faced criticism from its trading partners, notably the US, for its "grossly undervalued" exchange rate

By Hussain H. Zaidi

The good news for the US as well as other trading partners is that China has announced to make its exchange rate regime more flexible. The bad news for them is that at the same time Chinese central bank has ruled out any major change in the exchange value of its currency -- the yuan. Over the years China, has maintained a fixed exchange rate with the yuan pegged to the dollar, which it is widely maintained has resulted into an under-valued yuan thus making Chinese exports more price competitive than they would be in the event of a floating exchange rate.

In 2005, China allowed the yuan to appreciate but reverted to the pegged exchange rate in March 2009 in the face of the global economic slump and slowdown in exports. China has faced severe criticism from its trading partners, notably the USA for its "grossly undervalued" exchange rate. The issue was also discussed during the recently held G-20 summit in Canada. Beijing however resisted attempts to make any commitment to reform its exchange rate regime in the joint declaration issued at the conclusion of the summit.

The USA, the world's largest economy and the biggest trading nation, is facing huge fiscal and trade deficits -- the twin deficits as they are called. With the country's exports and imports standing at $1.05 trillion and $1.60 trillion respectively, the US trade deficit in 2009 stood at $547 billion. The principal source of the US trade deficit is cheap exports from China. The US trade deficit with China exceeded $226 billion in 2009, while in the first four months of 2010, the trade deficit was registered at $71 billion. Conversely in 2009, China's global exports and imports were $1.20 trillion and $1 trillion respectively giving the country trade surplus of $196 billion. China has also overtaken Germany as the world's largest exporting country.

The USA attributes its increasing trade deficit with China in the main to the undervalued yuan. Ideally, Washington would want Beijing to adopt a flexible exchange rate. But realising that the Chinese banking sector is not prepared for that move, Americans are at present only calling upon China to re-value the yuan. The US has on several occasions threatened that in case China does not revalue its currency vis-a-vis the dollar, it may face punitive action including additional tariff on all Chinese exports to the US.

Economic theory tells us that no country can maintain huge trade surplus for long. This is simple. The value of a country's currency depends on the demand for its goods and services in international market. When, therefore, a country has a large trade surplus -- showing increasing demand for its goods and services -- the demand for its currency goes up and as a result it appreciates.

Currency appreciation makes the country's exports more expensive thus lowering its trade surplus. However, this mechanism works only when market forces are allowed to operate. If the exchange rate is fixed by the government, then increase in trade surplus will not push up the value of the currency. This is what is happening in China, whose growing trade surplus has not pushed up its currency value proportionately.

Since China's economic growth is largely dependent on its export performance, the Chinese government is reluctant to let the yuan appreciate freely. The effect of an undervalued yuan is the same as that of a subsidy to exporters. Both make export price artificially lower than it would be if left to market forces and thus push up demand for exports. Interestingly, though there are clear-cut World Trade Organization (WTO) rules regarding subsidies -- subsidies on industrial products are not allowed if they have the effect of distorting production or price and the importing country can impose additional duties on subsidised exports to offset the effect of subsidies -- the global trade regime lacks rules regarding an undervalued exchange rate. However, a country faced with balance of payment problem -- just as the US is facing -- can levy additional import duties.

In case China revalues its currency, Chinese exports to the US will become less competitive, which will bring down demand for them. Thus as US sees it, a re-valued yuan will help correct US balance of trade with China. The US assessment is, however, only partly correct. No doubt, yuan is undervalued with respect to the dollar, but this is only one possible cause of US trade deficit with China. What makes Chinese exports competitive in the US market is low input costs particularly labour cost in China, economies of scale and China's highly subsidized state-controlled economy.

In 2006, China became the first country to have foreign exchange reserves of $1 trillion. As of March 1, 2010, Chinese foreign exchange reserves stood at $2.44 trillion, the largest holding of foreign exchange reserves by any country. The huge accumulation of foreign exchange reserves can mainly be attributed to China's emergence as a major player on the global export scene and its trade surplus of $196 billion.

Trade balance is a major item on the current account balance. A country's current account deficit is financed by inflow of capital from its trading partners having current account surplus. The US current account deficit is in large measures financed by China by investing in long-term US treasury bonds and other government securities. It is estimated that China has invested $700 billion in US long-term bonds. In case China decides to disinvest its holding of US bonds, the US dollar will come down with a thud increasing inflation in the US and destabilizing the global economy. But such a move would also lower the real value of China's own foreign exchange reserves.

While the possibility of an American punitive action on the Chinese exports is always there, several factors militate against such a move. In the first place, US-based multinational corporations (MNCs) have invested heavily -- to the tune of $25 billion -- in China to take advantage of a huge market and economies of scale.

A great deal of what China exports to the world, including the US, is produced by these MNCs. Hence, clamping punitive duties on Chinese exports will also penalise the US businesses, which are lobbying against such a move. Secondly, additional duties on the Chinese exports would harm American consumers, who are getting inexpensive goods. Thirdly, an undervalued yuan means cheap exports to the US of consumer goods, which is necessary to keep the inflation in check. As mentioned above, in China, the US gets a credible source of funding for its current account deficit. Imposition of duties may force China to disinvest part of its holdings of the US government securities thus pushing the dollar down and causing great inflationary pressures on the US economy.

China being the leading nation among the developing countries and the US being the leading nation among the developed countries hold the key to the successful implementation of the Doha Development Agenda (DDA), which will determine the future of multilateralism in trade represented by the WTO. Probably more than any other country, these two can help bridge the differences among developed and developing nations.

In case the US takes punitive action against Chinese imports in an attempt to correct its trade imbalance, it will not only strain their bilateral relations but is also likely to sharpen differences between the developed and the developing countries and further stalk the DDA. Besides, trade restrictions may impinge negatively on China's headway towards market economy.