China's yuan exchange-rate conundrum

Jun Zhang, Project Syndicate

China's abrupt decision to raise the value of the renminbi (yuan) by 2.1 percent and to end its peg to the dollar comes after months of pressure from the U.S. This surprise change in policy is likely to hold for some time because a stable currency remains in China's interest.

Indeed, economist Robert Mundell, whose work on optimal monetary zones is credited with laying the theoretical groundwork for the euro, insists that China should maintain its fixed exchange rate as a necessary part of its current phase of economic development. But, owing to China's skewed economic structure, its exchange-rate regime presents much more challenging problems than those encountered by Japan and other East Asian economies.

Pegged exchange rates clearly have been essential to East Asia's economic takeoff, for they work well with the region's export-oriented development model. But the effectiveness of a fixed exchange rate is determined by how developments in the export sector influence domestic industries and the national economy as a whole. If growth in the trade sector boosts that of domestic non-trade sectors, then a fixed exchange rate will not put pressure on the external balance of payments as demand for imports rises.

Under these circumstances, revaluation of the exchange rate will not have a severe impact on an economy's development. For example, Japanese economists argue that the Plaza Agreement, which called for "orderly appreciation" of non-dollar currencies against the dollar, was a natural outgrowth of high national income. This was one of the major reasons for Japan's acceptance of the change.

But China's current situation is vastly different. Pressure for revaluation comes at a stage when per capita national income is merely US$1,000, not $10,000 or $15,000, so China still needs a rather long period of rapid economic growth to reach anything like the stage that Japan had achieved when it allowed the yen to be revalued.

Equally important, unlike other East Asian economies during their early take-off stages, the expansion of China's export sector in the last decade has not been closely linked to the development of its domestic non-trade sector, because the expansion has been fueled mainly by foreign direct investment (FDI). Most of China's 460,000 foreign-owned enterprises are concentrated in manufacturing and assembling, increasing the import-intensiveness of exports and de-linking the external-trade sector from domestic industries.

This helps to widen regional disparities, especially between eastern and western China, with the wealthiest regions being those that have benefited from high concentrations of FDI. No one should realistically expect the renminbi's exchange rate to be determined solely by the income level of the relatively prosperous eastern coastal regions.

To be sure, China has accumulated an enormous balance-of- payments surplus, which indicates that the renminbi is greatly undervalued. But the surplus merely masks the structural problems of China's domestic economic sectors and poorer regions. Indeed, if foreign-owned enterprise exports are deducted from the total trade volume, the surplus vanishes, because both the overall balance of merchandise trade and the balance of trade in services normally run deficits.

In short, the isolation of the export sector from the rest of China's economy, caused by the dominance of FDI, accounts for the illusion of an undervalued renminbi. Although the expansion of exports has been dramatic, now accounting for 70 percent of China's GDP, it has exerted no pull on other economic sectors, because it has been confined to foreign-owned manufacturing and assembling enterprises. With its huge domestic economy, China would never have been able to accumulate such an enormous external surplus if its growth had not been confined to such enterprises.

Pressure for revaluation stems, therefore, not from the real needs of China economy, but from large imbalances in the United States, particularly its long-standing trade deficit, which exceeds 5 percent of GDP. However, dollar supremacy means that the U.S. can sustain a much wider balance-of-payments deficit than other countries.

As long as Asia holds its foreign reserves in dollars -- a policy that continues to offer tremendous advantages for trade and economic development -- China's desire to maintain a stable value for the reminbi will continue to offer tremendous advantages for trade and economic development.

The writer is Director, China Center for Economic Studies, Fudan University, Shanghai.