December 8, 2015

Fighting the Last War? China, Currency Manipulation & US Trade Deficits

The Economic Policy Institute recently issued very interesting trade policy paper by Rob Scott entitled Setting the Record Straight: Unfair Trade Practices — Not High Wages — Have Hurt U.S. Manufacturing  (hereafter SRS).

The SRS paper provides useful insights regarding the trade policies and wages for China, Germany and the United States. One valuable contribution of the paper is its analysis of why Germany has a competitive advantage in manufactured exports despite  wages that are higher than in the U.S. (A future ABCD post will address this and other issues regarding exchange rates, capital flows, and the trade imbalance problems currently facing Europe.)

This post, however, focuses just on the issue of whether or not America should be blaming its trade deficit problems on currency manipulation by the Chinese rather than examining the problems being caused by America’s own international monetary policies – policies that are seriously out of line with the realities of the 21st century.

This post concludes that blaming Chinese currency manipulation is like beating a dead horse from the last currency war. If America wants to restore the vibrancy and international competitiveness of its manufacturing sector, if it wants to put millions of people back to work in good jobs, it needs to shift its policy focus to two far more important tasks.

First, America needs to understand that the world is changing rapidly, that many facts from the past are only myths today. It needs to understand why profound changes in the way exchange rates are determined make 20th century policies obsolete. Second, America needs to develop international monetary and trade policies that are relevant to the 21st century realities of a highly financialized world.

Currency Manipulation is to Blame for America’s Trade Deficits -
Yesterday’s Fact, Today’s Myth

Consistent with the meme popular in America today that China, not America, is to blame for America’s manufacturing and trade problems, the SRS paper states that China's currency manipulation and unfair trade practices are a "growing threat to manufacturing output and employment" in the United States and that “the Chinese currency remains heavily undervalued relative to the U.S. dollar (emphasis added).

Yes, many of China's trade practices including theft of intellectual property, state supported dumping/subsidization of exports, and non-tariff barriers that restrict the access of US products to China's internal markets have hurt and will continue to hurt US manufacturing and America's balance of trade; these need to be dealt with through appropriate trade agreements. However, let’s focus here just on the SRS paper's comments regarding China's currency manipulation.

In warning that China's currency manipulation is a growing problem, the SRS paper is fighting the last war with the wrong weapons. This assertion is based on (a) recent research by Bill Cline of the Peterson Institute, and (b) the IMF’s recent inclusion of the yuan in the SDR basket. After discussing these developments, this post concludes with recommendations for an international monetary policy change that America can implement, unilaterally if necessary, a change that would replace policies that were failing even in the 20th century with policies that will help restore the vitality and global competitiveness of the American economy in general in the 21st century – and the manufacturing sector in particular. 

The Peterson Institute Says the Chinese Yuan Is Properly Valued

 Both of the currency reviews for 2015 by Bill Cline, the Peterson Institute’s leading currency expert,  indicate that, although the yuan was undervalued in the past, this is no longer true. In his latest review, Cline notes that:

"The Chinese renminbi remains consistent with its fundamental equilibrium exchange rate (FEER), despite depreciating modestly against the US dollar in August as China moved toward greater market determination of the rate." 

Cline’s most recent paper also provides a link to data from earlier reviews. These data indicate that, between April 2012 and the present, the yuan's undervaluation was less than the dollar's overvaluation for six of the eightsemi-annual reviews. In fact, speaking of the dollar, Cline also found that:

“The US dollar is now overvalued by about 10 percent, comparable to its levels in 2008 through early 2010 and again in 2011. Unlike then, the current strong dollar does not reflect a weak renminbi kept undervalued by major Chinese exchange rate intervention. Instead, China's current account surplus has fallen sharply relative to GDP, and its recent intervention has been to prevent excessive depreciation rather than to prevent appreciation."  

Furthermore, Cline's analysis, which uses the IMF's World Economic Order (WEO) projections through 2020 as the baseline, indicates that the dollar was overvalued by 8.0% in April 2015 and by 8.9% in October 2015. In contrast, the yuan was overvalued by 0.1% in April and undervalued by only 0.9% in October. America’s loud complaints about China’s misaligned currency are clearly a case of the pot calling the kettle black! 

From these facts one must conclude that China is no longer "manipulating" its currency. It is no longer pursuing policies that keep the yuan's value artificially low. It is no longer realizing current account surpluses that are inconsistent with fundamentally balanced trade over the medium term. Currency manipulation is clearly not a "growing" threat to America's manufacturing output and employment as stated in the SRS paper.

The SRS paper also states that “the Chinese currency remains heavily undervalued relative to the U.S. dollar.”  This conveys the completely erroneous implication that the Chinese currency is seriously undervalued.

How, you may ask, can a currency be heavily undervalued relative to the U.S. dollar without itself being undervalued? The answer is easy. The yuan is fairly valued, but the dollar is seriously overvalued.

The idea that we can determine if the Chinese yuan is over- or under-valued simply by comparing it to the U.S. dollar is simply wrong. Whether or not a country’s currency is under- or over-valued should be based, not on the bilateral trade balance between any two countries, but on each country’s multilateral trade balance. For example, the United States might run a trade deficit with China, but this does not mean that their respective currencies are misvalued or misaligned. Bilateral trade is rarely balanced, and there is no reason that it should be.

The only relevant question is this: Is America’s total trade balanced? Yes, there may be legitimate geo-strategic reasons related to America’s financial, economic, and military security for avoiding excessive deficits with a given country like China because this could indicate an over-dependence on that country for strategic goods, but such cases are relatively rare and should be handled by mechanisms other than exchange rate policy. From an exchange rate perspective, the key issue is simply whether or not America’s total foreign trade is reasonably well balanced (i.e. within one percent of zero measured as a percentage of GDP). [1]

Given Cline's finding that China’s currency is fairly valued, a finding consistent with the IMF's position as discussed in the next section, the SRS paper's statement should be rephrased to read, “the U.S. dollar remains heavily overvalued relative to the Chinese currency – and to all other global currencies on average."

Furthermore, Cline's analysis indicates that currency manipulation by China is not a threat today, much less a "growing" threat as stated by the SRS paper. This being the case, why should American policy analysts be focusing on policies designed to prevent China from doing what it is not doing and on raising the value of a currency that, according to careful analysis by the world’s leading experts in currency valuation, has already reached its fundamental equilibrium rate?  

The IMF, the Chinese Yuan, and the SDR Currency Basket

The IMF's recent decisions regarding the Chinese yuan and the SDR are another major recent development indicating that the Economic Policy Institute and other groups such as the Alliance for American Manufacturing and the AFL-CIO would do well to shift their focus away from beating the currency manipulation war drums, and to focus instead on preventing the next currency war. 

When the IMF completed its Article IV Consultation with China on May 26 of this year, it announced that:

"While undervaluation of the renminbi was a major factor causing the large imbalances in the past, our assessment now is that the substantial real effective appreciation over the past year has brought the exchange rate to a level that is no longer undervalued."

This finding was key to the IMF's decision to recommend that its Board approve the yuan’s inclusion as one of the major currencies constituting the Special Drawing Rights (SDR) basket. On Nov. 30, 2015, the IMF announced the results of the latest SDR review:

A key focus of the Board review was whether the Chinese renminbi [yuan] met the existing criteria to be included in the basket. The Board today decided that the RMB met all existing criteria and, effective October 1, 2016, the RMB is determined to be a freely usable currency and will be included in the SDR basket as a fifth currency, along with the U.S. dollar, the euro, the Japanese yen and the British pound.

Now that China has attained the IMF's endorsement of the yuan as a major international reserve currency, it is unlikely that China will back-slide and resume manipulating its currency. The rewards of manipulation are nothing compared to the benefits China perceives of the yuan’s being chosen to join the elite global group of SDR currencies.

From Past to Future – Strategies for the 21st Century

Although data from the Peterson Institute and the IMF confirm that the Chinese yuan is no longer undervalued, America does need to implement policies that will accomplish one major currency-related goal:  Tie the dollar's exchange rate to balanced trade.

Keeping the dollar’s exchange rate consistent with balanced trade will help America attain two other important goals: (a) reduce the risk of another round of beggar-thy-neighbor currency devaluations, and (b) neutralize the negative impacts of any future currency manipulation by foreign countries.

Once these goals have been accomplished, it will be far easier for America to reduce tariff and non-tariff barriers facing U.S. exports by entering into trade agreements along the lines of the Trans-Pacific Partnership (TPP). The American public will be far more willing to support such valuable initiatives once a mechanism in place to assure that such agreements will not cause growing trade deficits and growing net job losses. 

The Tectonic Shift in Exchange Rate Determination

To understand why the value of the U.S. dollar today is the most overvalued of any currency in the world according to the latest PIIE data, and why the mechanism for setting the value of the dollar and other major currencies must be changed as soon as possible to restore balanced trade, it is necessary to understand the fundamental but generally unrecognized paradigm shift over the past fifty years in the way exchange rates are determined and in how the mechanism works (or should I say, does not work) today.

Following the collapse of the Bretton Woods system, which starting in the late 1940s had tied all currencies indirectly to gold through a pegged rate with the U.S. dollar, the current floating rate system developed starting in the 1970s. In theory, the market-driven floating rate system was supposed to maintain balanced global trade much the gold standard had done going back to the 1800s: when a country imported more goods and services than it exported and paid for the difference by printing more of its national currency, this currency would lose value in global markets. As a result, imports would become more expensive in this depreciated national currency, and domestically produced exports would become cheaper in terms of foreign currencies. Consequently, imports would decline, exports would rise, and balanced trade would be restored.

However, the changes that started taking place global trade in the 1970s rather quickly began turning this floating rate (non)system into a disaster, especially for the United States.

In a nutshell, cross-border capital flows increased rapidly starting with the Oil Crises of the 1970s and early 1980s as OPEC countries recycled their petro-dollars to U.S. banks. These banks then loaned out the funds, not only within the U.S., but also to foreign borrowers, especially in Latin America. This triggered a series of defaults and debt crises in the following years, including the Mexican Peso Crisis of 1994, the South-East Asian Crisis in the late 1990s and the American boom-bust crises associated with the Tech Bubble and later the Housing Bubble in the 2000's.

Despite repeated crises, international capital flows continued to grow rapidly. In fact, they grew so fast that they soon overwhelmed the volume of global import/export trade. Today, for example, enough foreign exchange enters the United States from abroad in about four hours to finance America’s total annual trade deficit – and the cross-border capital inflows during about two weeks of trading exceed total US imports and exports of real goods and services for an entire year!

Consequently, exchange rates are now set primarily by international trade in financial assets rather by trade in real goods and services. Not surprisingly, any correspondence between the market exchange rate determined in this manner and the exchange rate needed to balance trade in real goods is simply an accident, one that has not happened in America for nearly 40 years.  

No wonder the United States has lost so many jobs and factories and has piled up such large debts to foreign countries! But what to do?

A Strategy for the Future

Contrary to the position stated in the SRS paper, America’s trade deficits today with China are no longer the result of Chinese currency manipulation. Instead, they are primarily the result of the dollar’s overvaluation, an overvaluation that has been driven by the fundamental change over the past 50 years in the way exchange rates are determined – and the failure of U.S. international monetary policies to respond appropriately to this tectonic change.

Continuing to bash countries like China with charges of “Currency Manipulator” is like traveling down a dead-end alley in the dark, a trip with virtually no hope of success and quite substantial risks.  Bergsten and Schott (2015) have noted that, “No multilateral enforcement actions to counter currency manipulation have been taken in the almost 70-year history of the postwar economic system.” Why should we think that the demonstrated economic and political impossibility of nailing any foreign country for currency manipulation is going to change?

As for risk, China has already shown its complete willingness to go against the wishes of the United States economically, politically, and militarily. Consider, for example, its leadership in establishing the Asian Infrastructure Investment Bank (AIIB) as an alternative to the American-dominated World Bank and its military expansion in the China Sea.

The best possible way to (a) reduce the risk of another round of beggar-thy-neighbor currency devaluations, and (b) neutralize the negative impacts of any future currency manipulation will instead be to tie exchange rates to balanced trade.

If the exchange rates of all countries were tied to balanced trade, any country that tried to seek unfair competitive advantage through unilateral devaluation would soon find that the deficits in other countries caused by such action would trigger automatic exchange rate adjustments that would restore balanced trade, thereby neutralizing the impact of the devaluation and any gain that otherwise might have been secured through such devaluation.

The Market Access Charge (MAC) proposed elsewhere on this blog site is exactly what is needed to attain these goals, and the MAC would accomplish these goals in a highly effective manner that is fully consistent with all relevant international laws.

How would the MAC work? In a nutshell, whenever the U.S. dollar was significantly overvalued as indicated by a trade deficit exceeding one percent of GDP, a small charge starting at 50 basis points would be imposed on all incoming capital seeking to access U.S. financial markets. This would moderate the inflows causing the dollar’s overvaluation, allowing the dollar to move back to a more competitive level that would balance U.S. imports and exports.

If China or any other country were to begin manipulating the value of their currency against that of the U.S. dollar, causing the U.S. current account deficit to rise, the MAC charge would kick in when the deficit reached the one percent of GDP trigger point.

By slowing the inflow of excessive foreign capital, the MAC would cause the dollar to move to a more competitive value, automatically neutralizing any gain that a currency manipulator might otherwise gain. In like manner, the MAC would also be highly effective in neutralizing any negative effects on the U.S. current account balance of unfair trade practices by other countries that artificially reduced the access of U.S. exports to their markets. If they were significant distortions, such practices would increase the U.S. trade deficit, triggering a countervailing MAC charge.


If America wants to restore its manufacturing sector, put millions of Americans back to work, and stop adding to the growing pile of debt owed to foreigners, it should stop fighting the last currency manipulation war and start focusing on strategies for the 21st century that would assure that the dollar returns to an internationally competitive level and remains there -- regardless of any unfair trade practices, including currency manipulation, that other countries might be tempted to introduce.


1. Setting the maximum acceptable deficit to between zero and one percent deficit is a tougher standard than the three percent margin allowed by the PIIE methodology. However, the methodology used here is preferable to the PIIE standard because the larger deficits allowed by the latter  needlessly accepts the unemployment of an additional two to three million Americans.

America Needs a Competitive Dollar - Now!

No comments :

Post a Comment

What do you think? Join the Conversation