BEIJING IS RIGHT TO IGNORE THE CURRENCY PLEAS / THE FINANCIAL TIMES COMMENTARY & ANALYSIS ( VERY HIGHLY RECOMMENDED READING )

Beijing is right to ignore the currency pleas

By Stephen King

Published: September 19 2010 20:28

While everyone in Washington thinks the renminbi should be revalued, not everyone in China agrees. Maybe the Chinese are right? It is, after all, easy to blame trade imbalances on the evil exchange rate machinations of others. In the mid-1980s Japan’s surplus was supposedly the consequence of a deliberately undervalued yen. But while the yen has since risen a good deal – as shown by last week’s decision by the Bank of Japan to lower the exchange rate – its surplus has stubbornly grown too.

Now it is China that attracts Washington’s ire. The US rightly recognises China as its global rival in the 21st century, one reason Beijing is unenthusiastic about caving in to Washington’s demands. But China’s reluctance also reflects more justified doubts. The conventional wisdom was expressed clearly by Tim Geithner, the US Treasury secretary, in his congressional testimony last week: undervaluation “helps China’s export sector and means imports are more expensive in China than they otherwise would be”, thereby leading to lower domestic consumption. This argument assumes that movements in nominal exchange rates lead to lasting adjustments in competitiveness, and also that these in turn will deliver reductions in current global imbalances. Both the arguments are badly flawed.

On the first, China’s per capita incomes are still low, about $3,000 per annum compared with $40,000 in the US. The gap is slowly closing because of the way China’s new openness has attracted high-quality capital and management which, in combination with a surplus of remarkably cheap labour, makes China super-competitive. In other words, China’s growing share of world trade has nothing to do with undervaluation.

Moreover, a revaluation would do little to change China’s competitive position. The most important resource misallocation in China is under-utilised labour. China’s almost limitless reserve of poor rural workers constrains how quickly wages can rise – given that modestly higher wages attract more labour to its booming cities, which in turn limit further wage gains. Should the renminbi appreciate, those limits would become even greater and a temporary loss of export competitiveness would be offset by lower domestic wages. China’s leaders, therefore, are quite right to argue that a rise in the exchange rate would achieve little beyond the very short term and would harm China’s workers in the long term.

The second assumption is just as doubtful. It is true that policymakers persistently strive to shift exchange rates as means of economic “rebalancing”. Japan tried in the 1980s, but as its exports softened so its economy boomed, paving the way for the late-1980s bubble and the deflationary stagnation that followed. In the UK, sterling fell in 2008, but trade performance remains miserable. China could quite fairly cite either example as a reason not to move aggressively.

But does the rise in Beijing’s foreign exchange reserves not prove that China is manipulating its exchange rate? Even here I am not convinced. China is likely to want to switch out of US debt into a broader range of assets, including American companies. Yet Congress could hardly be less enthusiastic. Indeed, given the House of Representatives tends to prohibit Chinese takeovers on national security grounds, China is almost obliged to invest its surplus in dollars.

Because China is now the second-biggest economy in the world, by definition any renminbi appreciation is simultaneously a dollar depreciation. So after all of this, it is probably more accurate to describe America’s exchange policy as one of dollar devaluation, rather than renminbi revaluation – reflecting not America’s trade difficulties but its excessive debts. Should the dollar decline, the value of all those Treasuries issued to support America’s financial system would be worth a lot less in renminbi terms. And that, to the Chinese, would feel suspiciously like a default. No wonder they are not keen on seeing a rise.

So what can be done? The US needs to pull back from what is becoming increasingly protectionist rhetoric. Americans should not forget that their own fiscal stimulus has been possible only thanks to the deep pockets of creditor nations such as China. Sanctions would simply send the world into a downward spiral of protectionism, exchange rate upheavals and interest rate shocks.

Far better, then, for the US to recognise that mutual dependence between these two superpowers makes any such threat counterproductive. Meanwhile, the US should work with Beijing to push much-needed social security and consumer credit reforms in China’s domestic economy. Until these happen, and Chinese households learn how to spend rather than save, China’s current account surplus will not go away, no matter where the renminbi ends up.

The writer is chief economist at HSBC and author of ‘Losing Control: The Emerging Threats to Western Prosperity’

Copyright The Financial Times Limited 2010.