Chinese Whispers – Be Careful What You Wish For

June 25, 2010

The eurozone’s internal contradictions were removed from the spotlight last weekend, as
the focus returned to global imbalances upon China’s announcement that it intends to
gradually relax the peg between the renminbi and the U.S. dollar. The Middle
Kingdom’s decision to return to the arrangement that was suspended at the height of the
global financial crisis during the summer of 2008, has been taken ahead of the G-20
summit in Toronto, and should serve to ease strained Sino-American trade relations.
China’s exchange rate policy has been a matter of considerable political debate in the
U.S. and could be used as a platform for votes in the upcoming mid-term elections. The
Nobel laureate, Paul Krugman, has thrown his intellectual weight behind the debate, and
has argued that the Middle Kingdom’s, “policy of keeping its currency, the renminbi,
undervalued has become a significant drag on global economic recovery. Something must
be done.”
C. Fred Bergsten of the Peterson Institute for International Economics has rallied behind
Krugman, and both suggest that China’s exchange rate policies are “protectionist.” They
believe that the renminbi needs to appreciate by roughly 25 to 40 per cent against the
U.S. dollar to correct the problem. However, their analyses may in fact be wrong, in
which case, they should be careful what they wish for.
The tone of the criticism is remarkably similar to the commentary that accompanied the
growing frustration with the expanding American trade deficit through the 1970s and
1980s. Germany and Japan were the supposed culprits for America’s ills in the early-
1970s, and criticism of their export-led growth was all too evident in the Nixon
Administration. Japan was the noted trade villain throughout the 1980s, but even the
sharp appreciation of the yen following the Plaza Agreement in 1985, did little to
improve the American trade position. The pattern of international trade is far more
sophisticated today, and it is unclear whether a significant appreciation of the renminbi
would do more harm than good to U.S. interests.
China’s influence on the world economy has increased enormously since its accession to
the World Trade Organisation towards the end of 2001. Its current account surplus grew
from less than three per cent of GDP in 2003 to more than 11 per cent of GDP at the 2007
peak, and was almost six per cent last year, despite a sharp drop in exports. Krugman and
Bergsten believe that the competitive exchange rate has caused substantial job losses in
the U.S. and will continue to do so in the future if current policy goes unchallenged.
Indeed, the former estimates that if the status quo prevails, roughly 1.4 million jobs will
be lost in the years ahead, while the latter reckons that the required trade adjustment
would create an additional 600,000 to 1,200,000 jobs.
Krugman and Bergsten’s analyses however, fails to account for the fact that China’s
emergence as the manufacturing workshop of the world has positioned the Middle
Kingdom at the centre of a complex global supply chain for tradable goods. The
country’s rise as an export platform has been accompanied by a surge in imports from its
Asian neighbours, as it sources goods for further processing and eventual re-export to the
developed world. Furthermore, U.S. exporters source competitively-priced components
from the Middle Kingdom and retain the additional value added once the goods are sold
in international markets. Thus, a significant appreciation of the renminbi would not work
quite as neatly as envisioned by the critics. Indeed, such an action could depress growth
throughout East Asia, and importantly, from a U.S. perspective, result in the loss of
American jobs.
The timing of the escalating criticism of China’s exchange rate policy is also difficult to
comprehend. The global financial crisis and the subsequent collapse in international
trade forced the Chinese albeit belatedly, to reconsider their export-led growth model.
Unprecedented monetary and fiscal stimulus measures allowed China’s economy to
recover more rapidly than others from the “great recession,” with growth finishing 2009
at almost nine per cent. It could well be argued that no other country did as much to pull
the world out of its economic malaise. Indeed, U.S. exports to China are already 20 per
cent above pre-crisis levels – perhaps the intellectual heavyweights should be applauding
rather than criticising China’s efforts.
China’s decision to introduce more flexibility into its exchange rate regime is a welcome
development ahead of the weekend’s G-20 summit in Toronto, but trade tensions are
unlikely to disappear anytime soon given the mid-term elections in the U.S. later in the
year. The pro-jobs argument espoused by China’s critics may well win votes, but a
closer analysis of international trade and its complex web of bilateral relationships,
suggests that a significant appreciation of the renminbi could in fact contribute to higher
unemployment. The critics should be careful what they wish for.

www.charliefell.com

The views expressed are expressions of opinion only and should not be construed as
investment advice.
© Copyright 2010 Sequoia Markets