The Chinese central bank has announced that it is departing from the practice of the last two years of pegging the renminbi (RMB) to the dollar and returning to the earlier practice of allowing some appreciation of the currency under a managed float regime. The shift meant that in the first two days of the week starting 21st June, the RMB had appreciated by around 1 per cent relative to its Friday close. While this may be a small shift when compared with estimates of a 50 per cent undervaluation of the currency, it appeared an indicator of the direction in which its value could go.
The announcement has been received extremely well by the markets. The euphoric market response to the appreciation seemed easy to explain. Countries like the U.S. that incur a huge deficit in their trade with China could hope for some correction of the “imbalance” because of an increase in the dollar price of Chinese exports and a fall in the local currency prices of the country’s imports. If this reduces China’s exports to and increases its imports from the U.S., the latter’s deficit would decline leading to some degree of rebalancing.
There are others like India who not only look for improvement in their trade with China, but expect to gain a competitive advantage vis-a-vis China in third country markets because of a rise in the foreign exchange price of China’s exports, such as its exports of textiles.
Thus, what is surprising is not the initial euphoria, but the fact that it is being rather quickly replaced by an air of uncertainty about the implications for the world economy. The first source of uncertainty is whether a significant the expected trade and current account adjustments would actually be realised given a range of possible alternative outcomes. To start with, if past experience when a similar exchange rate policy stance was announced by the Chinese central bank is any guide, the actual appreciation of the currency may be far short of what is required to neutralise the competitive advantage China built up during the period when its currency was pegged to the dollar. China’s declaration may be just a move to diffuse criticism at the upcoming G20 meet when a number of countries were expected to place the onus for global imbalances on China’s exchange rate policies. Once the meet is done with we may return to business as usual without seeing significant benefits for competing countries.
Further, even if the appreciation of the RMB is significant, the U.S. may not gain, because the reduction in China’s exports to the U.S. may not result in increased demand for U.S. goods but for imports from third countries that are now more competitive than China in the U.S. market.
The appreciation may not result in global rebalancing, which reduces America’s aggregate trade and current account deficits, but merely to a change in the trade balances between the U.S. and China.
Finally, the appreciation of the RMB may not correct global imbalances involving China for one other reason. Even if China’s trade and current account surpluses are reduced, expectations of a currency appreciation can encourage a kind of carry-trade, in which investors borrow in foreign currencies and invest in China’s markets, not only to profit from local markets and activities but also to gain from the appreciation of the RMB. Hence China would still have large foreign exchange surpluses which would flow to countries like the U.S., dampen interest rates and encourage the consumption and dissaving that underlay the recent crisis.
A second cause for uncertainty is the potential fall-out for growth in China if the RMB does indeed appreciate significantly. China is substantially dependent on exports for growth as of now. If its export competitiveness is adversely affected by currency appreciation and the economy’s growth potential is impaired because this adverse export effect is not neutralised by an increase in domestic demand, then Chinese growth would slow. This would curtail China’s demand for raw materials, capital goods and energy, which would slow global growth, rather than increase such growth.
Finally, when China recorded a rapid rise in its current account surpluses, it accumulated reserves which flowed to the U.S., especially into U.S. Treasury Bills. If the renminbi appreciates significantly over the medium term vis-a-vis the dollar, this could not only reduce the pace of reserve accumulation but require a high return on dollar assets to take account of the expected depreciation of the dollar relative to the RMB. Both of these would mean that if the U.S. government’s deficit is to be financed by Chinese credit, the cost of borrowing would be higher. This can only have adverse implications for U.S. growth, especially at a time when the U.S. government is seeking to come to terms with the deficit increase and debt accumulation that resulted from its response to the financial and economic crisis.
All in all, therefore, there are many reasons to be sceptical of the argument that an appreciation of the RMB is good for global rebalancing and global growth. Not surprisingly the initial euphoric response to the announcement of a likely appreciation of the RM is being quickly replaced by a sense of uncertainty and a call for caution.