The Yuan Also Rises?

For a variety of reasons, Chinese economic policy makers resist pressures to allow the yuan (or renminbi) to rise against the dollar.  On this side of the great pond (i.e., the Pacific Ocean), politicians (see H.R. 2378 Ryan-Murphy bill) and many economists clamor for explicit pressure that “forces” the Chinese to allow the yuan to appreciate.  What would happen if the yuan were to rise markedly against the dollar?  Several observations are worth making.

1.  Much of the trade deficit that exists between the US and China arises from the sale of final goods.  The value added by Chinese firms in these goods, however, is rather small.  So what?  If the yuan rises, it means that Chinese firms will be able to purchase intermediate goods more cheaply than at present; thus, the decrease in the cost of Chinese goods in yuan terms will counter the rise in the exchange rate and limit the change in prices to American consumers.

2.  It’s not clear that changes in the nominal exchange rate drive large changes in purchasing.  For example,  the Japanese yen was forced to appreciate against the dollar in the late 1980s.  Such a rise has had limited impact on trade with Japan.  The U.S. runs trade deficits with virtually all of its major trading partners.  This is a natural outgrowth of diminishing savings relative to (tangible) investment over past three decades.

3.  On a related point, Gillian Tett, in today’s Financial Times argues that the Japanese experience with a rising yuan could be replicated in China.  Unless China reforms its banking and financial system in a way that decentralizes the allocation of capital, it may suffer the economic stagnation that Japan has suffered for the past two decades.  Cheap capital, centrally allocated, tends to yield excess capacity in politically sensitive industries.  I have heard this argument on many occasions in China.  If China’s economy were to suffer a long period of weakness, demand for US, European, and Asia goods would diminish, not rise.

4.  The iron triangle or impossible trilogy restricts countries from having a) open capital markets, b) a fixed exchange rate, and c) independent monetary policy at the same time.  Different countries, based on the depth and breadth of their domestic capital markets and their social time preferences, as well as their desire to attract capital, make different choices.  China chooses some combination of capital controls and limited monetary independence along with a fixed exchange rate.  The US and Europe, with much more developed capital markets, choose to allow exchange rates to float.  Small countries, dependent on world trade and world interest rates, such as Hong Kong and Estonia, forgo independent monetary policy.  There is no right choice.  Each country manipulates the tools it believes give it the highest level of economic welfare.

My advice to US policy makers:  be careful what you ask for.