Revaluing the RMB – Part 1
There has been a lot of posturing of late in regard to China’s undervalued currency. However, despite the repeated calls from officials within the US government, there is very little talk about the potential implications of such a move and the whether or not it would address all, or indeed any, of the issues perceived as a consequence of an undervalued Yuan.
In this post, I’d like to look at some of the likely ramifications of any potential revaluation of the Chinese currency. For the first part, would a revaluation really do much to address Europe and the US’ trade deficit with China?
In many respects, the simple answer is no. The reason for this – as I touched on the last post – is that the price competitiveness of China’s exports are only partially explained by an undervalued currency. What in fact continues to fuel China competitiveness in global trade terms is the continued supply of cheap labour into the industrial sector. As I mentioned last week, this flow of rural labour has depressed industrial wages for the last twenty years as pointed out in a recent article in the China Daily, illustrating the fact that China’s proportion of GDP spent on wages over the past 22 years has constantly declined, year-on-year.
In these terms, it might be worth recalling the example of Japan and their ill-fated revaluation in the mid-80s. Despite a de-facto doubling of the Yen in value against the USD during the period – again under pressure from Washington to reduce the trade deficit – Japan continued to maintain a 50-70bn USD trade surplus with its trading partner almost constantly since the revaluation largely because its competitive advantage was not primarily based on an undervalued currency. But instead on technological advantage. Likewise, China’s undervalued currency represents only a small part of its competitive advantage with low cost labour constituting the lion’s share. (As I pointed out in my last post, even accounting for a revalued Yuan, Chinese labour costs are still vastly more competitive than those of many other countries)
This aside, there are yet more compelling reasons to suggest that a rapid revaluation of the Yuan might be counter-productive as a measure for reducing the EU and the US’ trade deficit. One of the most compelling of which is the way in which trade figures are calculated.
The problem is, that base line trade figures are calculated exclusively from customs statistics – figures that greatly over simplify the realities of global trade, and more specifically the nature of Asian production cycles. This oversimplification occurs because customs figures are a simple summation of the overall value of all products leaving China for destinations such as the US and the EU. What this figure fails to take into account, given that production cycles in the Asia region have become increasingly geographically diversified over the past 20 years, is the true value added in the China stretch of the production cycle.
Given that many ‘China exports’, as calculated by customs statistics, are in fact composed of components manufactured in Japan, Korea and Taiwan – whose implicit value is not calculated in RMB, but in the currencies of the respective countries – the real level of added value created by the production process which occurs in China is often as little as 50 percent of the total book value of the finished good.
Added to this, it remains likely that Chinese manufacturers would be forced to further cut margins in an effort to remain competitive in global terms. Failing this, there is good evidence to suggest that consumers in the EU/US trading blocks would simply switch their purchasing habits to goods manufactured in other low cost emerging economies to supplement their addiction to low cost Asian import goods as Chinese export prices rose in relative terms.
What this implies, in real terms, is that a revaluation of the RMB, even one as large as 20-25 percent of the current value as defined against the USD, given the relative weighting of China imports in the US trade deficit calculation, might impact global trade deficits by as little as 5 percent. Given the these factors it seems extremely unlikely that a revaluation would have any significant effect in alleviating the real gripe of those who complain loudest against China’s currency policy; namely, the creation of jobs and the promotion of the domestic manufacturing sector.
Indeed, on the contrary, there is good evidence to suggest that such a revaluation might in fact have a far reaching negative impact on the regions that currently argue so fervently in favour of it.
One the one hand, substantial increases in the price of Chinese imports to the EU/US region would almost certainly help to fuel inflationary pressures in those regions; at the same time such a revaluation would most likely trigger an interest rate rise, especially in the US, as a shrinking of China’s trade surplus inhibited its ability to continue its investment in US financial assets, most notably US Treasury Bonds – of which it is currently estimated to hold somewhere in the vicinity of 1.2 trillion dollars worth.
In the second part of this post, I will attempt to look at some of the possible domestic ramifications of a significant revaluation of the RMB.
Revaluing the RMB – Part 2
In the last post in this series, I looked at whether a revaluation of the RMB would actively address the trade imbalances and job destruction highlighted by the most vocal of its proponents.
In this post I would like to address some of the likely domestic implications of a valuation.
In these terms, a substantive revaluation would clearly hold numerous, and obvious, benefits for China.
Firstly, unpegging the RMB from the US Dollar would greatly increase China’s autonomy in terms of monetary policy as well as give Beijing more tools with which to control inflationary pressures. Added to this, the relative cost of imported products, and much more importantly raw materials, would fall. An important consideration for a nation that is now a net importer of energy in every category; not to mention a huge consumer of iron ore.
Furthermore, easing restrictions of capital flows by moving toward a more marketised exchange rate would allow Beijing to strangle illegal capital flows fuelling speculative real estate investment as well as go a considerable way to making the RMB a global currency greatly enhancing China’s presence and prestige on the global financial stage.
However, the inherent dangers of any rapid, substantial revaluation may well undermine all of these potential benefits. Potentially creating a disruption within the Chinese economy that could lead to a contagion that might, given world’s current dependence on China as an engine of growth, filter back through the global financial network to create unexpected and unwanted feedback across the world’s developed economies.
Firstly, the Chinese industrial landscape is fundamentally different from its US and EU counterparts. Many, many enterprises in China operate on profit margins that would be deemed incremental elsewhere in the world. For this reason, a rapid revaluation, and hence loss of competitiveness in foreign markets, could well have a knock on effect throughout the economy as the shaky financial structures of domestic sub-contractors begin to feel the squeeze. That said, whilst this, in and of itself, might in the longer term actually help Beijing in its stated aims of consolidating many of the disparate industrial sectors that contribute to inefficiencies within industrial production in China, a clumsy, heavy handed approach to this would no doubt further fuel fears of social dislocation and industrial unrest.
A rapid revaluation could also be disastrous for the agricultural sector. As mentioned in another recent post on this site, real incomes in the Chinese countryside have never punctured the 40 percent of urban incomes ceiling. Indeed, for almost half of the last fifteen years real incomes in the Chinese countryside have in fact fallen. This is at least in part due to the relative lack of competitiveness by global standard. The ensuing benefit gained by international producers by a higher value Yuan would almost certainly spark social unrest in the agricultural sector as impoverished rural workers see the fabled lifestyles of the city dwellers slip ever further from their grasp. A very serious worry for a government that has already staked its credibility on being able to close, or at least mitigate, the rural/urban divide.
Added to these potentially disastrous outcomes, the Chinese financial sector remains in its infancy in terms of its overall market sophistication – even in spite of huge bank recapitalisations in recent years. Perhaps the biggest problems arise from China’s relative lack of experience in handling floating exchange rates with many in the sector lacking fundamental knowledge in risk management and hedging instruments designed to protect against the risks involved in managing a floating rate system.
Last, but by no means least, a steep, rapid revaluation would mean huge losses for China, with more than 70 percent of its foreign reserves invested in US dollar denominated assets. In short, such a revaluation, as called for by many foreign commentators, some arguably courting domestic audiences, would be unlikely to address the global trade imbalances affecting economies around the world – but could instead have wide reaching negative implications for China, and hence the globalised world.
Instead, perhaps those seeking to redress trade imbalances might take another lesson from the Japanese experience. A nation that has managed to maintain a trade surplus with China despite China’s huge advantage in cost competitiveness.
In the next post in this series, I’ll look at how Japan has managed to do this.
Is the undervalued Yuan really a red herring? Is China’s economic miracle dependant upon artificially low wages?
As an article in the China Daily recently points out, the proportion of China’s GDP that goes to wages has been steadily declining for 22 years. This revelation is in stark contrast to China’s neighbours who also followed export driven models. So the question is, is China’s continued competitiveness really due to a forced, and prolonged, stagnation of industrial wages?
China’s pre-eminent success at implementing an extreme mode of the East-Asian export driven economic miracle has been dependant upon a number of critical factors; both domestic and international. On one hand, China’s emergence onto the global stage coincided with the an unprecedented explosion in international trade that saw the traditional industrial workhorses of the world embark on a program of de-industrialisation the likes of which had never been seen before, beginning in the 1980s. This explosion was driven primarily by two factors – a dismantling of capital restrictions around the world and the ubiquitous adoption of containerisation.
As China adopted the model already proven by economies such as Japan, Korea, Hong Kong and Taiwan, the world was teetering on the edge of the single greatest shift in manufacturing patterns since the dawn of the industrial revolution. And as the western world’s appetite for cheaply produced foreign imports grew, China was set to take full advantage of its enormous levels of cost competitiveness locked within its massed pools of cheap labour. But that doesn’t explain why China was able to remain so competitive long after other countries following similar models found their competitive edge dulled. Taking a closer look at the other nations that have followed similar export driven models, it looks possible that urban biased policies and neglect of rural development may have forced industrial sector wages to stagnate – keeping China cheaper, longer.
Arguing against this point, many international observers contend that China’s competitiveness is due to fixed exchange rate system that many contend pitches the Yuan at an artificially low level against major currencies – most notably the dollar. However, even if the Yuan were to appreciate by as much as many of the fiercest critics in the US administration currently demand, 20-30 percent, that would still not make Chinese industrial wages anything close to that of its most comparable neighbouring economies – for the sake of argument say, Korea or Taiwan.
Another school of thought contends that China’s continued tapping of vast rural inland labour pools has created the illusion of unlimited supplies of cheap labour – appearing to go on long after many comparable countries ran dry at equivalent levels of development. But a closer look at the underlying economics paints a slightly less obvious picture.
In many ways, this illusion of bottomless pools of low cost labour can be seen not, in fact, as a function of population structure – but as a consequence of economic policies that, intentionally or not, slant the balance of economic development in favour of coastal populations at the expense of rural populations creating an almost unending exodus from the land.
The impact of China’s imbalanced development can be seen by comparing the country’s development with that Japan, Korea and Taiwan – societies composed of similar demographics in terms of rural and industrial composition during similar stages in their development.
In the case of all three of these economies, the rural/urban income divide never reached the polarised levels currently seen in China largely due to wealth redistribution programs and fiscal measures such as infrastructure spending, agricultural development loans and grants, tax relief, import tariffs, education spending and farm subsidies. This ensured agricultural workers remained on their land. Improved infrastructure meant factories could be built closer to rural populations, allowing the local populace to supplement their incomes without abandoning their ancestral homes to become full fledged migrant workers. These policies had two main consequences; the first saw rural incomes rise to between 60 and 95 percent of urban levels across the economies; the second was cut off the flow of cheap labour into the cities and industrial hubs, forcing urban wages up in return.
Although the overall effect of these policies across the three economies was largely similar – effectively removing the rural/urban wage divide – the motivations for implementing them varied. In the case of Japan, the ruling Liberal Democratic Party depended on the rural demographic to maintain it democratic mandate; in the case of Taiwan and Korea, in the context of the Cold War, it was to maintain food security and pre-empt any leftist sympathy emerging from the rural classes as a result of the social dislocation traditionally caused by rapid economic development.
This urban bias and the resulting redistribution of resources from country to town has created numerous negative effects within the Chinese economy.
One such negative effect of this agrarian crisis on the Chinese economy has been the creation of over-dependence on continued cheap labour. As comparable economies developed and industrial wages rose, this drove a corresponding development in overall economic efficiency within industrial production cycles as the relative cost of research and development fell in relation to wage costs. This would certain seem to be the case in China where energy input per unit of GDP has actually seen a net increase since the end of the Mao era.
Another negative effect has been to contribute to the excessively high savings rate across the economy. As I pointed out in a previous post addressing overcapacity, the savings rate is something of a misnomer in that it doesn’t necessarily mean that people are directly saving – instead it implies a more general disparity between production and consumption which can ultimately be fuelled by stagnating wages within a growing economy. This excessively high savings rate undoubtedly contributes to China’s over-dependence on the global economy and its inability to stimulate domestic demand in times of economic uncertainty.
But perhaps the most serious, given the government’s current fear of social turmoil is the simple desperation and hopelessness caused by the economic situation of those caught in the rural poverty trap.
In the next post in this series I will look at the reasons how this imbalance was created and way in which it can be addressed.