RENMINBI ADJUSTMENT WILL NOT CURE TRADE IMBALANCE / THE FINANCIAL TIMES COMMENTARY & ANALYSIS ( VERY HIGHLY RECOMMENDED READING - A MUST READ )

Renminbi adjustment will not cure trade imbalance

By Yang Yao

Published: April 11 2010 20:05

Earlier this month, the US Treasury announced it would postpone the release of its semi-annual report to Congress on exchange policies, which China’s critics hoped would name the country as a currency manipulator.

The delay is said to accommodate President Hu Jintao’s trip to Washington today to attend an international arms control summit, although the critics were hardly mollified.

In truth though, with or without the delay, do not expect the Treasury to cite China as a currency manipulator. If the Treasury was really serious about China’s currency intervention, it would have taken real action already. The Treasury can force China to end the renminbi’s peg on the dollar by stopping the sale of its bonds to China. The fact that it has not done so suggests it cares more about financing the budget deficit and the federal government’s spending programmes.

The sale of Treasury bonds to China is vital to maintaining the currency peg. As large amounts of dollars flow into China through net exports and foreign investment, the Chinese central bank must buy up these dollars at the pegged exchange rate. These purchases release equally large amounts of renminbi inside China, which will lead to inflation if the central bank does not also intervene and issue interest-bearing bonds to sterilise the excessive renminbi money supply.

Fortunately, because interest rates are lower in China than those on its US bonds, the Chinese central bank does not incur any accounting cost to carry out its sterilisation programme.

If, however, the Treasury stopped selling bonds to China, the Chinese central bank would have to convert its dollars in China to other currencies, such as the euro, and purchase euro-denominated assets. These purchases would drive up the value of the euro and increase China’s conversion costs. Those costs may be high enough to reduce returns on China’s foreign reserves below what the central bank must pay on its sterilising bonds.

At this point, to keep its accounts balanced, the central bank can either allow the renminbi to appreciate against the dollar so it needs to spend fewer renminbi to buy dollars, or to stop issuing sterilising bonds and allow domestic inflation. As domestic prices increase in China, Chinese goods will cost more dollars. Either way, the renminbi will appreciate.

Stopping the sale of Treasury bonds to China would benefit the US. First, it would prevent Chinese savings depressing demand for American goods. Second, it would discourage the US government from deficit spending and prevent skyrocketing government debts. Third, it would avoid a trade war, which would benefit no one. The inconvenient truth, however, is that the Treasury needs cheap Chinese savings to finance many more urgent spending needs, including the new healthcare plan.

Some people in the US want to have it both ways – they want the renminbi to appreciate and they want China’s continuous supply of cheap money. But even if China is somehow able to do both and revalue the renminbi, will that help the US economy?

Probably not – at least not in the case of moderate appreciation. Between July 2005 and June 2008, the renminbi appreciated against the dollar by 21 per cent on nominal terms, but China’s exports to the US still increased and trade surplus surged from $100bn in 2005 to $300bn in 2008. A sharper appreciation of another 20 per cent, as some have suggested, will probably have a stronger effect on the trade deficit but that will also kill growth of the Chinese economy, and China will never agree to that.

Often overlooked is the fact that the renminbi is only pegged to the US dollar, so its undervaluation against other currencies, if it exists, is the direct result of the dollar’s own devaluation. If the US really wants to help other countries, it should not devalue the dollar. The renminbi’s peg prevents a freefall in the dollar, so helps countries that earned and saved the currency while it was strong.

The trade imbalance between China and the US cannot be cured simply by adjusting the exchange rate. There are more fundamental concerns, such as labour market flexibility and the strengths of the two economies. We should focus on those and treat the exchange rate as something to be negotiated, instead of a political label used in antagonistic name-calling.

The writer is director of the China Centre for Economic Research at Peking University and editor of China Economic Quarterly

Copyright The Financial Times Limited 2010.