China’s central bank has widened the floating band of the yuan against the US dollar from 1 percent to 2 percent, after the exchange rate fell for the first time in many years.
The development sparked a new round of US Congressional furor at China’s “currency manipulation” and the threat of trade sanctions surfaced once again.
How large a bearing does the yuan’s exchange rate have on the Sino-US relationship? The question can be analyzed from three angles.
1. The history of exchange rate reform.
Ding Yifan
It has been a long time since China adopted a manageable floating RMB exchange rate regime but the floating range has been narrow. Over a fairly long period of time, the yuan was overvalued. The rate was 5.8 yuan to $1 in the 1980s. At that time, there was concern that the undervaluation of the yuan might lead to the flight of capital. To prevent that from happening, the government exercised a strict control over foreign currencies. Only two currencies were circulated in China at the time. One is the yuan, and the other is the RMB Foreign Exchange Certificate (FEC), the yuan’s surrogate exchangeable with foreign currencies. The yuan itself was not convertible, and the FEC was mainly used by foreigners.
As China had a planned economy at the time, a shortage of commodities was common. The FEC was endowed with the power to buy commodities in short supply at fair prices. That was a result of a scarcity of foreign currencies in China. That also accounts for why “export to earn foreign exchange” was once the most popular slogan of Chinese companies. To prevent the drain of foreign currencies, the government forced Chinese companies that had earned foreign currencies in overseas markets to convert their earnings into RMB immediately.
Due to the shortage of foreign currencies and the overvaluation of the yuan, the Chinese exchange rate against the dollar in the black market was much lower than the official rate; the former being 10 to one, with the latter being 5.8 to one.
The FEC was abrogated in early 1990s and the yuan-dollar exchange rate was set at a central parity of 8.7 to one. Soon, the trade of the dollar in the black market died down, indicating that the new official rate was accepted by the market.
A few years later, a financial crisis swept across Asia, with the currencies in China’s neighboring countries depreciating drastically. Facing the crisis, Beijing did not intend to fix the yuan’s exchange rate. However, China still decided to peg the yuan to the dollar in order to stabilize exchange rates in Asia and prevent the occurrence of a war among Asian currencies. The move demonstrated China’s sincerity in being a responsible member of the Asian community, but was seemingly overlooked by the international community who didn’t utter a single word of appreciation.
The practice of pegging the yuan with the dollar was not favorable for China’s economic development, as the Asian financial crisis occurred right at the time when the dollar was strong. In the late 1990s, IT bubbles inflated American stock markets, drawing a slew of foreign capital into the United States, which in turn pushed up the exchange rates of the dollar. The dollar-pegged yuan was thus overvalued. What is more, all of China’s neighboring countries had depreciated their currencies. These changes undoubtedly, at least in theory, caused a dramatic weakening of Chinese products’ competitiveness.
After the Asian crisis, the investment environment deteriorated in Southeast Asian countries because of the instability of their exchange rates. Many transnationals shifted their production to China. The stable exchange rates of the yuan became an attraction for the global giants to invest in China.
2. Disputes between China and the US over the yuan’s exchange rate.
After China joined the World Trade Organization at the end of 2001, foreign investment in China increased dramatically. Besides eyeing China’s market, overseas investors exported a large chunk of their China-made products to third countries. That’s why China’s exports and foreign reserves soared after the WTO entry.
China’s export consists of two parts: process trade and general trade. The former mainly stems from foreign companies’ production and exports in China. Apple’s iPhone is a typical example of process trade. It is completely manufactured in China but exported to the rest of the world. In process trade, a product’s component parts are imported to be assembled in China, and then exported to foreign markets. In international trade statistics, these products are counted as made in China and as China’s exports. But China’s manufacturers get only a small share of the profit. For example, China earns only $10 by assembling an iPhone.
Over a fairly long time period, process trade made up more than half of China’s exports. So the growth of China’s exports and foreign reserve was not necessarily part of China’s own economy, but more a result of foreign companies’ investment in China.
In 2003, Japan took the lead in blaming China, arguing that the magnificent growth of China’s exports was the result of a depreciated RMB. Then, some US congressmen also began to make an issue of the Chinese currency. They threatened to sanction China for what they called deliberate depreciation of the yuan, quoting the notorious Article 301. In the later Sino-US economic strategic dialogue, the yuan’s exchange rate was part of the discussions.
In 2005, China dumped the policy of pegging the yuan to the dollar. The yuan’s exchange rate began to float upward. According to the theory that a cheap yuan is the reason behind the strong growth of China’s exports, the appreciation of the Chinese currency would weaken Chinese products’ competitiveness, hence a decline in China’s exports. The fact, however, contradicts the theory.
After the yuan appreciated, China’s exports rose rather than fell. And China’s trade surplus soared not only with the US but also with other countries. China’s surplus with the US rose from $114.2 billion in 2005 to $170.86 billion in 2008, while total surplus in foreign trade reached a whopping $300 billion that year.
The reason was that China had restructured its economy to export more high-tech and high value-added products while lower-end industries were transferred to other Asian countries, especially Southeast Asian and South Asian countries. The US’ economy and that of China are mutually complementary. Although the yuan’s appreciation has made Chinese products more expensive, they remain indispensable in American markets. The higher the yuan’s value, the larger the trade gap between the two countries.
The 2008 financial crisis plunged the US, EU, Japan and other developed countries into recession, their market demands decreased drastically, thus leading to a sharp decline in China’s exports. To mitigate the impact of the dropped exports on the national economy, the Chinese government adopted a positive stimulus package to expand public investment. Starting from 2009, China’s energy and resource imports grew rapidly, making it the world’s largest importer after the US. Thanks to the appreciation of the yuan, imported goods became cheaper, which helped curb inflation in China.
3. A stronger yuan will create friction between the US and China.
Facts have shown that China has never intended to sharpen its competitive edge by undervaluing its currency. When the yuan was pegged with the dollar and was meanwhile overvalued, China’s exports didn’t suffer. And when the yuan appreciated, the US suffered a large trade deficit with China. That only proves once again that the two economies are highly reliant on each other. It also attests to the absurdity of the allegation that Beijing manipulates its currency. The issue has been nothing but an excuse used by some US politicians to stoke up fear of “China threat.”
China’s imports kept growing in recent years, leading to a reduced surplus in its international current account. In 2008, that surplus accounted for 10 percent of the GDP. In 2013, however, it plunged to account for only 3 percent and may continue to fall to 2 percent this year. Given these changes, American politicians would no longer find it easy to label China a currency manipulator.
China replaced the US to become the world’s largest trading nation in 2013. China’s imports also make up a larger percentage of the global economy. The US imported $2.27 trillion of goods in 2013 while China imported $1.9 trillion. It is likely that China will surpass the US in 2015 to become the world’s largest importer.
As China has become one of the largest importing nations, its currency is bound to gain a larger influence. In 2013, the amount of China’s imports and exports that was settled with RMB accounted for a much larger share – reportedly one fifth – of the total number of trade deals than it had previously. As the Chinese government has decided to let the RMB be internationalized, more and more overseas cities have joined the mission to become an RMB offshore market, with Hong Kong leading the pack followed by Singapore, London, Frankfort, Paris and Luxemburg. Everybody wants a share of the pie.
However, the yuan is not mature enough to become an international reserve currency. China needs to open its financial market wider. The opening of capital accounts is the touchstone for the yuan internationalization. In international monetary studies, there is an Impossible Trinity theory, which states that a country cannot hold an independent monetary policy, a free capital flow and a stable exchange rate at the same time, and that the realization of any two targets must be based on the abandonment of the remaining one. China will open its capital account and must maintain its independent monetary policy, so it has to give up the fixed exchange rate to allow a free fluctuation of its currency. At present, with the capital account becoming gradually opened, the yuan is floating at a larger and larger margin. During this course, however, the yuan may depreciate, as was the case not long ago. Some American politicians may continue blaming China for currency manipulation but they won’t have more opportunities to do so.
In fact, China knows well that artificial depreciation of currency is not a beneficial deed. It may stimulate exports but a more open financial market will create greater opportunity for foreign investors to buy domestic asset at lower prices. Besides, to become a currency favored by foreigners, the yuan has to acquire a strong, stable buying power. A constantly depreciating currency wouldn’t win their favor. Therefore, in the future, Americans may not worry about the yuan being undervalued but will rather worry that a rapidly appreciated yuan would erode the dollar’s supremacy and thus share the benefits enjoyed by the traditional international reserve currency.
Ding Yifan, Deputy Director, Research Institute of World Development, China Development Research Center (DRC).
