On exchange rates, think multilaterally

Image credit: frankenstein at Flickr under a Creative Commons license.

When U.S. policy-makers come to Beijing for their Strategic Economic Dialogue, one of the contentious issues is China’s exchange rate policy. Some fresh perspective on the issue can be gained by looking at China’s exchange rate in a multilateral context. After all, China’s largest trading partner now is the Euro zone, and China is Japan’s largest trade partner – so the yuan-euro and yuan-yen rates are as important as the yuan-dollar rate in today’s world.

To simplify these complex relationships, economists like to look at the trade-weighted or "effective exchange rate." This tells you what is happening to the yuan on average against all China’s trading partners (with each weighted for its importance in China’s trade). In 1994 China started to peg its currency to the U.S. dollar at a rate of 8.3 yuan per dollar. But it’s interesting that the effect of this choice of "stability" for the currency was to bring about gradual and sustained appreciation of China’s effective exchange rate from then until about 2002 (click here to see Chart 1). Over that period on average the U.S. dollar was appreciating against China’s other trade partners and China followed the dollar up.

This turned out to be a good exchange rate strategy for China. You can see in Chart 2 that from 1994-2002, China had a modest current account surplus that did not change very much. As a developing country with rapid productivity growth, China’s external accounts were kept roughly in balance by the gradual appreciation resulting from the link to the dollar.

The problems for China began early in the 2000s, as the dollar began to devalue against other major currencies in the wake of large fiscal stimulus in the U.S. Since China had good results from the peg to the dollar during the 1990s, it was a natural choice for the country to stick with the peg. However, in this new environment, the Chinese yuan then followed the dollar down – the effective depreciation from 2002 until 2005 was nearly 20 percent. Combined with the ongoing productivity growth, this devaluation led to rapid expansion of the export sector and the expansion of the external surplus to a whopping 12 percent of GDP in 2007.

While it was nice to have this kick to growth, this surplus was not in China’s interest. As a developing country with a high rate of return to investment, it does not make sense for China to export capital on this scale. The effect of the large surplus was to put a lot of liquidity into the system that then fueled booms in the stock market and real estate. Also, the export sector expanded too much, and now is almost certainly faced with serious over-capacity. 

In retrospect, China stuck with its peg to the dollar for too long. It started to appreciate against the dollar in 2005 and since then has appreciated a cumulative 18 percent. With the recent global financial crisis, the U.S. dollar has appreciated – somewhat ironically, since the crisis originated in the U.S. – against other currencies. You can see in Chart 1 that the effective appreciation of the yuan in the past half year has been extremely sharp. The cumulative effective appreciation since 2005 is about 30 percent.

What do I conclude from this? The fixed exchange rate policy served China well in the 1990s and did not produce any large imbalances. However, by sticking with the peg for too long in the early 2000s, China did itself some harm through asset inflation and excess investment in the export sectors. As a result of the effective appreciation since 2005 we are now starting to see a decline in China’s external surplus. It is in everyone’s interest for the decline in the surplus to be gradual. Too rapid a decline would be a big shock to China’s real economy and would drastically reduce the financing available for the external deficits of the U.S. and many developing countries. While the U.S. wants to gradually reduce its external deficit, it will need significant financing for the next several years.

There is a lot of potential for misunderstanding in this area. China feels that it has had a rapid effective appreciation and now wants to see what the real effects are before going further. The U.S. is probably looking at a substantial devaluation of the dollar against other major currencies, as the immediate financial crisis wanes and the U.S. needs to rein in its consumption and save more. If that happens, it is not in China’s interest to follow the dollar down. It will take good coordination between China and the U.S. to resolve their large imbalances in a smooth manner.