The debate over the exchange rate between the renminbi (RMB) and the dollar is usually framed in terms of global imbalances: excessive US consumption beyond its savings on the one hand and excessive Chinese production and savings beyond its own spending on the other. This quickly leads to the view that the United States should export and save more and China import and spend more. The debate centers on how to achieve this rebalancing. The focus in the West is on short-term appreciation of the RMB, while the emphasis in China is on longer-term structural and institutional reform.¹

Leaders in the United States would like the RMB to appreciate significantly and quickly to encourage an expansion of US exports and employment. Chinese leaders, however, regard the pressure to revalue the RMB and various protectionist trade policies from the West as unfair, and believe they threaten China’s development.² What accounts for this considerable gap between the views of China and the West? What is the economic rationale for China’s insistence on a stable RMB?

The argument for a sustained appreciation of the RMB is rooted not only in short-term concerns about China’s large current account surplus, but also in longer-term trends of China’s economic fundamentals, including high growth, rapid urbanization and industrialization, low national debt, and low fiscal deficits. These trends are the result of three decades of reform in China that have opened the country to trade with the rest of the world and led to strong productivity gains. Based on the experience of other fast growing industrializing economies, these forces will increase Chinese wages, the value of the RMB, and China’s price level—over time.

China’s stance

China views its RMB peg with the dollar as a crucial link for its trade and investment flows with the United States and world markets. China is concerned that a premature end to this nominal link with the dollar would bring about financial instabilities such as speculative capital inflows, associated asset bubbles, and unfair short-term nominal shocks to employment and business in the external sector.

China has not forgotten how the large appreciation of the yen brought about by the 1985 Plaza Accord created massive asset bubbles that burst in 1989, creating a two-decade-long period of sustained deflation without eliminating Japan’s trade surplus.

China is also wary of how currency appreciation might encourage destabilizing capital inflows. From 2005 to 2008 the RMB appreciated steadily by about 5 percent a year and China’s stock market index increased from about 1500 to 6000 before falling to 2000 because of large speculative capital inflows from Hong Kong. If China were to use RMB appreciation to reach a balance in trade and to stop speculative capital inflows, the RMB could overshoot its equilibrium level, leading to bubbles and deflation.

Another reason for not having predictable RMB appreciation is related to China’s outward investment. For a country with a large net surplus savings and trade surplus, a well-functioning financial system should support orderly private or non-state capital outflows of the same order of magnitude as the trade surplus. But private firms and financial institutions would be reluctant to buy dollar assets if they are likely to continually depreciate in terms of RMB. Because the fear of dollar depreciation, and the near-zero short-term interest rates in the United States, reduces outward investment by private-sector investors, the Peoples Bank of China has to finance virtually all of China’s trade surplus by building up official exchange reserves, making its monetary control difficult.³

In any case, it is not clear that nominal RMB appreciation is necessary. The real exchange rate between the RMB and dollar should be self adjusting. That’s because the change in China’s price level relative to that in the United States (the “real exchange rate”), is technically the sum of RMB appreciation against the dollar and China’s extra inflation above US inflation. This real exchange rate is determined largely by China’s productivity growth. If China appreciates its currency in excess of its productivity gains, it will experience deflation. But if China refuses nominal appreciation against its productivity gains, the country will experience some structural inflation related to the increase of wages and prices in the non-tradable sector, which will keep the real exchange rate compatible with its productivity changes. If China experiences inflation higher than its productivity gains, the RMB will face depreciation pressure.

Indeed, if China makes the mistake of continually appreciating the RMB against the dollar, ostensibly to reflect its higher productivity growth in manufacturing, then wage growth could well slow down by roughly the amount of the anticipated exchange appreciation. Manufacturing firms would risk bankruptcy if they raised wages in the face of an ever-higher RMB. Indeed, in Japan’s very high growth phase in the 1950s and 1960s, when the yen was safely fixed at 360 to the dollar, Japanese wages grew very rapidly, at about the same pace as domestic productivity growth in manufacturing. Then, when Japan was forced by the US government to appreciate in the 1970s and afterward, wage growth slumped to virtually zero and remains at zero today.⁴ China does not want to repeat Japan’s experience of deflationary stagnation by allowing excessive RMB appreciation.

It should also be noted that recent research by Hong Qiao in 2007 has shown that currency appreciation has an ambiguous impact on the net trade balance. Qiao’s research is clearly consistent with Japan’s experiences and supports China’s current exchange-rate policy.⁵

When it comes to rebalancing, what really matters is the real exchange rate; the relative price levels between economies, which determine relative costs of production, exports, and imports of trading partners. Hence, if China pegs the RMB to the dollar, it can still achieve a rapid increase in its price level relative to that in the United States by having an inflation rate of five percentage points higher than that of the United States. Many formerly fast-growing industrializing economies, such as Japan, South Korea, Taiwan, and Hong Kong, kept inflation around 5 percent to 8 percent during their fast-growth phases as a way to make nominal wages and general price levels converge towards global standards.

Hence, both inflation and appreciation can adjust price levels. The Chinese approach to exchange-rate stability thus far has focused on inflation first and appreciation second, which makes the longer-term objectives of creating employment, productivity gains, wage growth, and price liberalization the priority rather than addressing trade imbalances through adjustments for exchange-rate change.

Policy alternatives

Given the fact that China refuses to use nominal appreciation to rebalance the Chinese and global economies, at least for the time being, it is important to consider some alternative policy options. A widely held view in China is that the rebalancing should focus on reducing the net savings surplus by shifting disposable income to households, paying corporate dividends, increasing government’s fiscal spending, and so on—and not simply on adjusting the exchange rate.

China is well known for its high savings rate, which reached about 55 percent of GDP with a current account surplus of about 10 percent of GDP, during 2007–2008. One of the key reasons for China’s high national savings rate is its state-owned enterprises (SOEs), as corporate savings contribute about half of China’s national savings.⁶ Historically, these large SOEs could not pay high salaries and wages to their employees due to tight control by the government. They did not distribute dividends. Even after they were reformed into a modern corporate format in the 1990s, the primary focus was on reducing losses, not sharing dividends. They also did not generate private purchasing power when the prices of their shares increased, which created huge capital gains with no wealth effects on consumption. The high savings of SOEs are prone to investment into overcapacity sectors. Hence, privatization and deregulation are necessary to reduce savings and inefficient investment by the large SOEs.⁷

While China clearly must increase its current consumption, consumption is ultimately limited by income. China has a long way to go in raising the wages and productivity of its workforce. Right now, household income accounts for only 35 percent of national income. The situation is especially acute when it comes to migrant workers who do not receive high-quality education in rural villages. Their wages have been stagnant at a level of about $120 to $200 per month for the last three decades due to steady high unemployment for unskilled labor.

Chinese savings are also high because the average Chinese household is faced with a very high return on investment, such as in residential property. In one of our studies on the comparative long-term return on capital for China, Japan, and the United States, we found that China’s return on capital is about 20 percent, compared to about 10 percent for Japan and 5 percent for the United States over the last three decades.⁸ Moreover, Chinese households save to meet very high future expenditures, such as college education for their single child and medical and retirement expenditures.

Addressing the West’s concerns

Chinese and foreign observers alike have expressed concerns about inefficient investment in China’s export manufacturing sector and in some local government-sponsored projects. As a result, China’s central government has recently tightened monitoring and control on all new projects, especially those likely to lead to overcapacity. But the Chinese authorities have not changed their overall stimulus policy and continue to focus on generating more efficient investment, employment, and imports so as to contribute positively to global rebalancing and global recovery.

For those who worry about China’s $2.2 trillion foreign exchange reserves, it is worth looking at a case that illustrates China’s need for foreign exchange. The number of self-financed Chinese study-abroad students increased from 102,247 in 2002 to 161,600 in 2008, which is a rate of about 8 percent a year. If we assume the number of such students will increase 8 percent a year for the next 10 years, then the number of students studying abroad will reach 348,882 by 2018. If each outgoing student spends four years overseas with $60,000 in expenditures per year for tuition, living expenses, and travel, the total accumulated expenditures for those Chinese students going abroad will reach $606.8 billion, amounting to about 30 percent of China’s current foreign exchange reserves. It is no secret that even high- and middle-income Chinese parents need to save for many years or decades to pay for their children’s expensive overseas education.

Price distortions and global rebalancing

One of the key factors driving the global imbalances has been cheap money, which, together with weak regulation of high-risk investment, led to property and stock market bubbles in the United States and other economies. The bubbles brought temporary capital gains that reduced Americans’ savings and increased their consumption to a level beyond their sustainable income. This is well known now. But what has been overlooked in the public discussion is that this same cheap money also flowed into China through foreign direct investment and other capital flows. Cheap foreign money, combined with cheap Chinese land, energy, and natural resources, has led to huge over-capacity growth in China’s manufacturing sector, driving down the prices of Made-in-China products.

The United States’ current zero-interest-rate policy may be necessary for the US economy now, but is likely to create a carry trade as a by-product, bringing capital flows into China in anticipation of higher investment return in China compared to that in the United States. If managed well, China can combine the foreign capital and its own savings to improve the efficiency of its investment, so as to allow higher levels of domestic investment for future domestic consumption, which would certainly help global rebalancing.

Rising Chinese household income and large official reserves mean that there will be rising demand for diversification by Chinese investors into foreign assets. Over time, the amount of cross-border capital flows involved could be much larger than the trade flows. To facilitate these future cross-border capital flows, it would be helpful for China to maintain a stable exchange rate and large foreign exchange reserves, both of which are critically important in reducing the Chinese and foreign investors’ uncertainty that would result from a volatile exchange rate. Having a stable exchange rate to facilitate cross-border investment is also important for the large number of US multinational corporations with extensive and growing investments in China that generate high value-added complementary jobs in the United States.

The future for China and the dollar

The biggest challenge for Chinese policymakers now is how to deal with the property and stock-market bubbles being formed by cheap money in China and around the world. As asset prices and the consumer price index rise, it is important for China to raise its interest rate, as India has done very successfully, to keep the real interest rate at a stable and positive level. A higher interest rate would attract greater capital inflows. So it is necessary for China to improve its capital control mechanisms, to allow orderly cross-border capital flows for more efficient investments with higher returns both domestically and internationally, while limiting the speculative flow of capital and the inefficient and low return investments.

So what does China’s policy stance mean for the dollar? There are some clear implications:

1. Given the institutional and structural constraints in China, it does not seem likely that nominal RMB appreciation will become a key policy variable in rebalancing China and the global economy in the near future. This means it will be difficult for the United States to pursue a weak-dollar policy. Without depreciation against the RMB, any further depreciation of the dollar against the euro and yen would do little to help global rebalancing, and might instead cause shocks to the European and Japanese economies.
2. Given the huge potential for cross-border investment and debt financing between the United States and China, a stable RMB-dollar exchange rate seems to fit both countries’ long-term national interest. If the United States and China can cooperate effectively in maintaining the stability of the exchange rate and orderly cross-border flows of capital, there is little reason to believe the dollar-based international currency system will collapse in the foreseeable future.
3. In the longer term, certainly after 2020 and perhaps during 2025–2035, the RMB is likely to become an international currency when it becomes fully convertible and the Chinese economy completes its structural and institutional transformation into a fully modernized market economy with a more democratic political system. By that time, the integration of the US, European, Japanese, and Chinese economies will be so deep that the dollar, euro, yen, and RMB are likely to become leading reserve currencies of the world, with fully floating exchange rates.

Rebalancing the world economy can be accomplished without revaluing the RMB. For this to happen without major dislocations, however, structural and institutional reforms must occur both in China and in the United States. Higher inflation in China and deflation or lower inflation in the United States can bring about the needed adjustment in real, rather than nominal, exchange rates. This implies a stronger dollar, but also requires deleveraging in the United States, including reduction of US fiscal deficits.

The author would like to thank Ronald McKinnon, Andrew Sheng, Pieter Bottelier, Wing Thye Woo, Jeffrey Sachs, Barry Bosworth, Harry Broadman, David Dollar, David Loevinger, David Meale, David Skilling, Jonathan Woetzel, Kenneth Lieberthal, Cheng Li, Xingdong Chen, Min Zhu, Qiren Zhou, and Hong Liang for helpful comments and discussions. Jonathan Delikat and Will Hobbs provided excellent research assistance.

¹ See my article “China’s Exchange Rate and Monetary Policies: Structural and Institutional Constraints and Reform Options,” Asian Economic Papers, MIT Press Volume 7, Number 3, pp. 31–49, 2008. Some of the key results are summarized and restated in this article.

² On November 30, 2009, in his meeting with European leaders, Chinese Premier Wen Jiabao said some countries on the one hand demanded RMB appreciation and on the other hand adopted various trade protectionisms.

³ See a series of articles by Ronald McKinnon about the exchange-rate policy in Japan and China; particularly the article by Ronald McKinnon, Brian Lee, and Yi David Wang, “The Global Credit Crisis and China’s Exchange Rate,” Stanford Center for International Development Working Paper number 391, Stanford University, June 2009.

⁴ See detailed analysis in Ronald McKinnon, “China’s Exchange Rate Trap: Japan Redux?” American Economic Review, 2006, Volume 6, Number 2, pp. 427–31.

⁵ See Hong Qiao, “Exchange rates and trade balances under the dollar standard,” Journal of Policy Modeling, 2007, Volume 29, Issue 5, pp. 765–782.

⁶ See Eswar Prasad, “Rebalancing Growth in Asia,” Finance & Development, 2009, Volume 46, Number 4, pp. 19–22.

⁷ For more on China’s SOEs, please see the discussion by Geng Xiao, Xiuke Yang, and Anna Janus, “State-owned enterprises in China: Reform dynamics and impacts” in Ross Garnaut, Ligang Song, and Wing Thye Woo (eds), China’s New Place in a World in Crisis: Economic, Geopolitical and Environmental Dimensions, Australian National University E-Press, 2009, pp. 155–178 .

⁸ Sun Wenkai, Yang Xiuke, and Xiao Geng, “Investment rate and FDI: A comparative analysis of return to capital among China, US and Japan,” a paper presented at the joint symposium of US–China Advanced Technology Trade and Industrial Development in Beijing on October 23–24, 2009.

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