Don't revalue the yuan yet
Ms. Wiemer is a visiting scholar at UCLA's Center for Chinese Studies and a visiting associate professor of economics at Claremont McKenna College.
Chinese Premier Wen Jiabao kicked off the new year by reiterating that China will not yield to foreign pressure to appreciate its currency. To his credit, he has a successful record of focusing currency policy on achieving domestic macroeconomic objectives and is right to continue on this course. This does not preclude an appreciation of the yuan when the time is right. But the time is not right yet.
Western critics who call for yuan appreciation see it as the cure-all for global trade imbalances. Yet China's external imbalance narrowed sharply in 2009, even as the country maintained a firm peg to the dollar at 6.8 yuan. Projections from research firm Dragonomics show China's current-account surplus as a share of GDP dropping by half in the last year to 5 percent. To the extent that critics register this trend at all, they dismiss it as a temporary aberration caused by a collapse in external demand for China's exports. As the global economy recovers, they maintain, China's trade surplus will expand again unless action is taken on the exchange rate.
Yet the exchange rate isn't a relevant factor in achieving a sustainable rebalancing in China's foreign trade. A surplus of exports over imports is simply the external manifestation of an excess of saving over domestic investment. Export revenues not spent on imports are used to acquire foreign assets, which represent Chinese saving invested abroad.
The critics may be right that the recent mitigation of imbalances will prove unsustainable, but this has nothing to do with the exchange rate. Rather, it concerns the way the saving and investment gap has been closed through expanded investment, as opposed to reduced saving and increased consumption. This is unsustainable because China's domestic investment as a share of GDP is already extremely high, at around 45 percent, and its system of allocating capital is inefficient. A government-backed stimulus program funded largely through bank lending has generated the bulk of recent investment gains. But investment on these terms is in danger of losing steam as projects fail to yield sound economic returns.
A long-term resolution of imbalances — both external and internal — must come from Chinese consuming more and saving less. There is not a plausible story for how exchange-rate appreciation would achieve this outcome. The argument is sometimes made that a stronger yuan would inhibit saving by cutting into enterprise profits. But saving in the form of enterprise retained earnings did not increase over the past decade, even as the national saving rate rocketed up. Rather, households and government were behind the explosion in saving. These seem the more promising targets on which to focus. In any case, if the objective is to encourage consumption by redistributing income from enterprises to households, more pointed mechanisms exist for doing so than the exchange rate.
The exchange rate itself has a far more important function in China as an instrument of macroeconomic policy. This is true generally for developing economies characterized by immature financial markets and capital-account controls that impede use of the interest rate as a policy instrument. Currency appreciation restrains growth and subdues inflation; conversely, depreciation stimulates growth and spurs price increases. Throughout the global financial crisis, the peg to the dollar has stabilized the Chinese economy. The time for the yuan to appreciate will have arrived when signs of overheating emerge and inflation becomes a threat.
Policies to stimulate consumption would actually hasten that day along. The expansionary effect of fiscal policies aimed at boosting consumption would find a ready counter in the contractionary impact of a rising yuan. Plenty of latitude exists to pursue such a strategy given the strong fiscal position the Chinese government enjoys.
The true magnitude of the fiscal surplus as of 2007 has only recently been revealed with the release of flow of funds data through that year. From a negative position stretching back to 1992, government net revenues broadly defined reached balance in 2005, then shot up to 5.3 percent of national disposable income in 2007. Much of this burgeoning net revenue was parked in bank deposits.
The last two years may have seen a slight easing in this fiscal tightfistedness. The stimulus program announced in late 2008 was valued at four trillion yuan ($580 billion). With much of the spending financed by bank lending, however, it seems reasonable to surmise that as of this year, the government possesses vast unutilized capacity to undertake the kinds of much needed consumption spending on health and education it has long talked up.
Critics who advocate yuan appreciation in and of itself as a mechanism to reduce trade imbalances are sure to be disappointed. But if they champion fiscal spending on consumption, they could get not only the narrowing of China's trade surplus they ultimately seek but a collateral increase in the yuan to boot.