Is the Chinese Yuan Too Cheap?

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So here we are, once again, in a nasty round of political bickering over China’s currency, the yuan (also known as the renminbi). There is a widespread belief around the world that Beijing has been setting the value of the yuan at an artificially cheap level, which gives Chinese exports an unfair advantage in international  markets. Just a few days ago, President Obama called on China to move towards a more “market-oriented” exchange rate, for the good of the global economy. Chinese officials have never looked kindly upon criticism of its currency regime, and this weekend, none other than Premier Wen Jiabao himself made some of China’s strongest protests yet. In a defiant press conference, Wen insisted that the yuan is not undervalued, then went on to blast:

What I don’t understand is the practice of depreciating one’s own currency and attempting to press other countries to appreciate their own currencies solely for the purpose of increasing one’s own exports. This kind of practice I think is a kind of trade protectionism.

I have to give Wen special kudos for having the sheer chutzpah to make such a comment, since it’s exactly what the world accuses China of doing. That stones-and-glass-houses irony was lost on no one. Yet to be fair to Wen, determining the proper value of China’s yuan is no easy task.

The conventional view is that China, with its giant trade surpluses, should have a much more expensive yuan, and the only reason it doesn’t appreciate is because the Chinese government won’t allow it to. However, economists have come up with wildly disparate estimates of where the yuan should be. I won’t bore you with the details behind these conflicting opinions (because they’re boring), but a quick trot through the basics will give you an idea of how complicated a currency the yuan has become.

The  Peterson Institute for International Economics figured in a January study that the yuan was undervalued in a big way and should appreciate a whopping 41% against the dollar from its current level. The International Monetary Fund has also come out clearly that the yuan is too cheap, stating in a February report that it was “substantially undervalued from a medium-term perspective.” But Jim O’Neill, head of global economics at Goldman Sachs, took the opposite view in a March report. Goldman’s models, he wrote, “used to show that the CNY was undervalued but it is not any longer.” Thus, he says, “the conventional and popular view concerning the CNY may no longer be true.” Here’s some of his reasoning:

It should not be forgotten that the CNY has risen by close to 20% on a trade-weighted basis in real terms, which has removed the undervaluation we estimated…There is tentative evidence of a significant change in China’s trade patterns since the credit crisis reached its maximum point with the collapse of Lehman Brothers. Import growth has made a spectacular recovery both in absolute terms, and relative to exports. As some Chinese policymakers have recently suggested, it is not inconceivable that China might be close to the end of trade surpluses.

So, which view is correct? The only way to know that for certain is to allow the yuan to trade freely and watch where it goes. Unfortunately, the Chinese government isn’t likely to help us solve this little economics conundrum anytime soon. China has actually regressed in regard to currency reform in recent years. In 2005, China ended its peg of the yuan to the U.S. dollar, a step that resulted a slow-moving appreciation of the currency. But in mid-2008, in response to the looming financial crisis, China effectively re-established that peg, and ever since the value of the yuan against the dollar has remained generally the same (at around 6.8 yuan to the dollar). The Chinese are intensely concerned that any rapid change in its exchange rate would undermine its export sector and thus its economic recovery. So even if China liberalizes its current currency system, don’t expect any drama. In my opinion, the best we can hope for is a back-to-the-future type of deal, in which Beijing returns to the system it had in place before the crisis, and again allows the yuan to trade in a narrow band and move at a glacial pace.

And there is widespread conviction that the yuan will in the near future start appreciating again. Even Goldman’s O’Neill forecasts that China will permit a 5% appreciation of the yuan over the next six to 12 months. That won’t happen as a result of American badgering; it will happen because China needs a stronger currency. A more expensive yuan can help policymakers restrain China’s galloping economy and control inflation. Here’s what O’Neill says:

China needs tighter financial conditions to ensure that the current buoyant rate of economic growth eases, and any inflationary pressures can be kept under reasonable control…We do think the likelihood of a CNY appreciation has increased, because it is now clearly in China’s interests, as well as those of the rest of the world.

That’s absolutely correct. Whether Wen Jiabao is right or wrong about the yuan’s fair value isn’t really the point. By stubbornly insisting on its current exchange rate system, China isn’t doing any good for itself or anyone else. A more liberal and transparent currency regime would help China’s policymakers manage their own economy, especially that crucial process of rebalancing away from its unsustainable invest-and-export system to a healthier growth model based on greater domestic consumption. That in turn would help alleviate those dangerous global imbalances – excessive savings in China, excessive spending and debt in the U.S. — that underpinned the current financial crisis. Beijing has yet to realize that its actions on economic policy impact everyone. Until that realization sinks in, the Chinese yuan will remain a political football, one that unfortunately hurts China’s relations with the rest of the world.