For years, China has been accused of being a “currency manipulator” by deliberately undervaluing its currency to spur exports. Official bodies like the International Monetary Fund softened the language by using the term “misaligned currency” and used sophisticated techniques to gauge how far the yuan was from its fundamental equilibrium value.
In 2011, former U.S. assistant treasury secretary C. Fred Bergsten contended that the yuan was as much as 30 percent below its equilibrium level, and that “China’s currency policy” should be regarded “as the most protectionist measure taken by any major country since World War II.”
One year earlier, Robert E. Lighthizer, deputy U.S. trade representative during the Reagan administration, argued that “the U.S. government should treat currency manipulation as a subsidy for purposes of our CVD law.” In other words, countries that intentionally undervalue their currencies to gain a trade advantage should be disciplined by imposing a countervailing duty.
Those arguments still persist as some members of Congress, such as Republican Senator Lindsey Graham and Democratic Senator Charles Schumer, seek to include provisions in U.S. trade bills that would penalize currency manipulators.
Yet, in a turnaround from past statements, the IMF has declared that the yuan is close to its equilibrium value. In making that announcement, the IMF’s first deputy managing director, David Lipton, urged China to move more quickly toward a floating exchange rate and away from its export-led development strategy — goals shared by President Xi Jinping and Premier Li Keqiang.
China’s current account surplus as a percentage of GDP went from 10 percent in 2007 to 2 percent last year, and the yuan’s trade-weighted real effective exchange rate has appreciated by nearly 15 percent over the last two years. On that basis, economist Tao Wang, of UBS Securities Asia Ltd., believes the yuan “is close to its fair value.” Of course, “fair value” is an amorphous term. The difficulty of knowing a currency’s true foreign-exchange value, in the absence of an open capital market and freely floating rates, is well known.
The IMF’s change of mind also stems from pressure to give greater recognition to China as the largest trading nation and world’s second-largest economy. Recognizing its currency as “fairly valued” makes it easier to include the yuan in the fund’s basket of reserve currencies known as Special Drawing Rights, and would be another step toward internationalizing the yuan. Yet, until the yuan is fully convertible, its role as an international reserve currency will be narrowly limited.
The real issue is not whether China is a currency manipulator, as many still contend, but rather how to incentivize its leaders to take the necessary steps to reform its ossified financial system, which still suffers from state control and central planning. The longer China postpones structural adjustments and continues to engage in financial repression, the higher the ultimate costs of adjustment will be.
A vibrant market economy requires flexible prices, including interest rates. The choice of an exchange rate regime will depend on the size and openness of an economy. Hong Kong’s currency board arrangement along with open capital markets and free trade under a genuine rule of law has worked well. But China’s size and importance in the international economy mean it is better suited to have an independent monetary policy and allow a freely floating exchange rate to bear the heavy lifting in bringing about external balance.
China has widened the bands around the official parity to avoid one-way speculation, but the exchange rate is still tightly controlled, as are cross-border capital flows. Authorities are expected to take another step toward capital account liberalization in the coming weeks by allowing individuals and businesses meeting certain conditions in free-trade zones to invest in foreign securities and other assets without prior approval.
Like other reforms, however, this one is an attempt to sanction what is already happening in shadow markets that have arisen spontaneously to get money out of the mainland into assets and areas that offer more secure property rights.
The lack of investment choices in China means wealthy individuals and businesses have a strong incentive to find better alternatives. Strengthening and privatizing the financial system — and allowing free markets, not state planning, to determine exchange rates and interest rates — would help retain scarce capital in China and put it to higher valued uses than under the current system.
The central banks of China, Japan and the eurozone have all used monetary policy to influence their currencies’ foreign exchange value, and the United States has been engaged in unconventional monetary policy for more than six years designed to suppress interest rates — a policy that could be interpreted as a form of currency manipulation. Indeed, U.S. President Barack Obama has voiced concern that adding currency provisions to trade law could “end up having a blowback effect on our ability to maintain our own monetary policy.”
The Obama administration needs trade promotion authority to conclude negotiations on trade agreements such as the Trans-Pacific Partnership. Burdening trade bills with currency provisions is a risky strategy driven by special interests wishing to protect their turf. Moreover, the WTO would not uphold any CVD law that treated undervalued currencies as an actionable subsidy.
China’s growth is slowing and the costs of financial repression are mounting. Accumulating vast foreign exchange reserves under a managed exchange rate system and using sterilization instruments (PBOC bills and bonds, and required reserves) to prevent inflation is not a viable long-run strategy.
The IMF’s call for more flexible exchange rates and structural reform in China, along with the likelihood of including the yuan in the fund’s basket of reserve currencies, are positive steps that will incentivize Beijing, as opposed to those in Washington who favor extending CVD law to penalize currency manipulators.
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