The RMB’s exchange rate is clearly an issue deserving the most precise economic analysis given that it involves the world’s largest exporter, China, and the world’s largest economy, the US. It might therefore seem surprising that a frequent feature of calls for early RMB revaluation are attempts to justify this through what are in a quite literal sense economic 'non sequiturs' - non-sequitur being Latin for ‘it does not follow’.
Such arguments consist of two sentences. ‘China runs a trade surplus. Therefore to eliminate it China should increase the exchange rate of the RMB.’
Unfortunately elementary economic reflection will show that the second sentence does not necessarily follow from the first. Consideration of supply and demand reminds us that an increase in the exchange rate of the RMB will only reduce China’s export earnings if demand for China’s exports is elastic – that is any percentage fall in sales is greater than any percentage rise in price resulting from revaluation. Equally China’s imports in value terms will only rise if any increase in their volume is greater than any fall in their price due to revaluation.
The question of whether China's trade surplus will fall or rise in response to RMB revaluation is therefore a matter of fact, not of logic, which therefore has to be examined empirically - as the paper below notes. It quite simply does not follow that an increase in China’s exchange rate will logically necessarily lead to a fall in China’s trade surplus. Indeed it is quite possible logically, for example if demand for China’s exports is inelastic, and the volume of its imports is not particularly price sensitive, that a rise in the RMB’s exchange rate will lead to an increase in China’s trade surplus.
Given the seriousness of the issue one would have thought that if this matter were being dealt with objectively the US administration would have produced a mountain of material to justify its claim that an increase in the RMB’s exchange rate would lead to a fall in China’s trade surplus - China has certainly produced abundant data, including directly by the Commerce Minister, showing the opposite. But no such material has been forthcoming from the US administration. Instead there is the intoning of a literal non-sequitur.
The reason evidence has not been produced by either the US administration or by those in agreement with it is that at least as regards the immediate and medium term economic situation their argument is factually false. As is shown in the paper below an increase in the RMB’s exchange rate would immediately lead to an increase in China’s trade surplus and not to a fall – and this is one of the last things which the world requires while attempting to emerge from the international financial crisis.
This paper was written in April and published in Chinese. It deals with a wider range of issues than simply bilateral China-US trade. The opening paragraph has been amended to remove purely contemporary references and altered to read in the past tense. The rest of the article is unchanged - its fundamental arguments do not require revising.
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At the meeting between President Obama and President Hu Jintao earlier this year the Chinese side noted that RMB appreciation would not balance Sino-U.S. trade. This conclusion reiterated other studies published by Chinese ministers and economic specialists on bilateral US-China trade. This conclusion is in line with the data below.
However it should also be noted that 84% of China’s foreign trade is with countries other than the US. A change in the RMB’s exchange rate would therefore have not only bilateral consequences between the US and China but wider effects on the world economy. This article therefore examines these. The most important conclusion it demonstrates is that:
- The immediate effect of an increase in the RMB’s exchange rate would be to increase China’s trade surplus and not decrease it – contrary to apparent expectations of the US administration;
It is important to understand this dynamic so that wrong anticipations of events do not exist in the US, China or elsewhere.
In addition:
- RMB revaluation would produce limited but distinct inflationary pressure not only in the US but in the international economy due to China’s position as the world’s largest exporter;
- As 84% of China’s trade is with countries other than the US the consequences for the rest of the world economy of early RMB revaluation would be greater than for the US.
- At present China is in trade balance or deficit with the rest of the world apart from the US – limiting trade frictions to a relatively few countries. RMB revaluation would probably shift China to running a trade surplus with the rest of the world apart from the US, widening the range of countries with which trade frictions are possible.
While Chinese economic policy makers may have valid overriding domestic reasons for an early increase in the RMB’s exchange rate, such as the struggle against inflation or to aid cooling the economy, this will not resolve trade issues. Indeed it should be recognised that in the field of trade there is a significant risk of negative trends created by an RMB revaluation which must be taken into consideration.
The aim of this paper is, therefore, to clarify factual understanding of what would actually occur if an increase in the RMB’s exchange rate occurred.
The empirical evidence on the consequences of an increase in the RMB’s exchange rate
The argument of those favouring an early increase in the exchange rate of the RMB is that as China runs a trade surplus it should revalue the RMB to reduce it. Unfortunately the second part of the argument only follows from the first if factually RMB revaluation would lead to a reduction in China’s surplus. This is an issue of economic fact - of the degree of the elasticity of demand for China’s exports and imports and of their independence of movement - and it does not follow as a matter of logic. Furthermore it is necessary to distinguish between effects in the short term and the long term.
If for example, other things remaining equal, over any given period of time the RMB’s exchange rate went up 10% but China’s export volume fell by only 5% then China’s trade surplus would actually increase due to RMB revaluation. For China’s trade surplus to fall after revaluation changes in the volume of China’s exports and imports would have to be sufficient to offset the fact that RMB revaluation will produce an increase in China’s export prices relative to import prices.
Most of those arguing for short term RMB revaluation make no attempt to demonstrate this factual linkage - they illegitimately claim it without proof. The reason they do not attempt to prove it is that particularly in the short term, which is crucial for the world as it emerges from the financial crisis, it is false.
The consequences of RMB revaluation
Factually, as a number of Chinese authors have pointed out, over the short to medium term it is unnecessary to rely purely on theoretical models to examine the consequences of an increase in the RMB’s exchange rate on bilateral trade with the US. As they note, the increase in RMB’s exchange rate from July 2005 to August 2008 led not to a decrease of China’s bilateral trade surplus with the US but to its increase. However this trend of China’s trade surplus increasing as the RMB’s exchange rate rose was general and not simply a bilateral one with the US.
Taking US figures for its own trade and the IMF’s for total trade, to avoid any suggestion of relying on China’s data which might be alleged to be biased, and to remove secondary differences on the calculation of bilateral US-China trade balances, the US trade deficit with China increased from $162 billion in 2004, the year before RMB revaluation, to $268 billion in 2008 – a rise of $106 billion or 65%. However over the same period China’s trade balance with the rest of the world moved from a deficit of $103 billion to a surplus of $93 billion – a movement of $196 billion in China’s favour. The factual evidence over a three year period therefore showed that an increase in the RMB’s exchange rate led to an increase in China’s trade surplus, and not to a decline, not only with the US but with the rest of the world economy.
This trend is shown clearly in Figure 1 - which graphs the way in which the increase in China’s exchange rate was accompanied not by a fall in China’s trade surplus but by an increase.
Figure 1
The trade surplus was due to a fall in the relative value of China’s imports
The explanation of why China’s trade surplus increased as the RMB’s exchange rate rose is clarified by Figure 2 - which shows China’s exports and imports as a percentage of GDP. As may be seen, prior to 2004, during the period of RMB exchange rate stability, China’s exports and imports rose in parallel as a percentage of GDP. Consequently no trade surplus developed.
From 2005 onwards, however, China’s exports continued to rise as a percentage of GDP but its imports began to fall. Factually, therefore, the emergence of China’s trade surplus was not due to acceleration of exports, as is frequently claimed, but to a relative fall in the value of China’s imports.
To judge from their statements US commentators, and others, advocating an early increase in the RMBs exchange rate do not appear to have studied this factual trend.
Figure 2
Why an increase in the RMB’s exchange rate led to an increase in China’s trade surplus
There is a clear economic explanation of the factual trends shown above – i.e. that as long as the RMB’s exchange rate remained stable exports and imports moved in parallel in value terms, and no trade surplus developed, but when as an increase in the exchange rate took place the total value of imports fell relative to the total value of exports and therefore a trade surplus develop. This trend would necessarily be the case if China’s exports and imports moved together in volume terms, or if the effects of the shifts in relative volumes were lower than the effects of the shifts in relative prices. In that case the effect of RMB revaluation would put up China’s export prices relative to its import prices, the changes in export and import volumes would be less that the effect of the rise in export prices relative to import prices, and therefore an increase in the RMB’s exchange rate would increase the trade surplus. The explanation of this tendency of exports and imports to relatively move together in volume terms would be if a large proportion of imports were inputs into exports – as is the case with China.
That this is the explanation of why the increase in the RMBs exchange rate after 2004 led to an increase in China’s trade surplus, and not to its reduction, is indicated in Figure 3, which shows the UN’s calculations for the movement of China’s exports and imports in fixed price, i.e. volume, terms from 1998-2008. As may be seen the volume of China’s exports and imports moved essentially in parallel throughout this period. Under those circumstances an increase in the RMB’s exchange rate would necessarily lead to an expansion of China’s trade surplus – as occurred.
Figure 3
The ‘J curve’ effect
To analyse the effect of RMB revaluation over an even shorter time frame, it will be assumed, simply for the sake of argument, that the long term effect of an increase in the RMB’s exchange rate would gradually break down the tendency of the volume of China’s exports and imports to move relatively in parallel – although, it may be noted that after July 2005 this did not occur over a three year period, and under conditions of a 21% revaluation, and therefore a considerable delay in adjustment should be anticipated. However even in this case the short term effect on an RMB revaluation would be to increase China’s trade surplus.
The reason for this is the well established short-term ‘J curve’ effect regarding currency exchange rate changes. Under this effect, when a currency’s exchange rate changes, it takes time for demand to adjust. Therefore in the short term, whatever the long term shifts, the change in volumes relative to the effect of price shifts is relatively weak. Revaluation increases export prices and reduces import prices. The ‘J curve effect’ of an RMB revaluation would increase China’s trade surplus in the short term.
However even a short term increase in China’s trade surplus would reverse the most significant present source of international demand and be negative for the world economy as it attempts to emerge from the financial crisis.
It may be noted that purely modelling studies on the long term effects of an increase in the RMB’s exchange rate on China’s trade surplus are mixed. Some find that it would lead to a fall in China’s trade surplus and some that it would lead to an increase. The empirical evidence of a three year rise with a 21% revaluation after 2005 is, however, that it led to an increase in China’s trade surplus and not a fall.
Unless the evidently implausible assumption is made that China’s economy can remain competitive no matter how high its exchange rate, at some point in a very rapid and very large revaluation the trend seen in 2005-2008 would be reversed, and a rising RMB exchange rate would lead to a fall in China’s trade surplus. However the empirical evidence is that such an increase in the RMB’s exchange rate would have to be of a very high percentage and of exceptional duration to reduce China’s trade deficit. Such a very sharp and very prolonged increase in the RMB’s exchange rate would, of course, do great damage to China’s economy and under such circumstances China’s trade surplus would only decline after it had continued to increase for possibly a significant period.
On any reasonable assumptions, therefore, the short and probably medium term consequences of an increase in the RMB’s exchange rate would be to increase China’s trade surplus and not reduce it.
The structure of China’s trade
Turning from the direction of change that would be produced in the short to intermediate term of an increase in the RMB’s exchange rate to its consequences, a picture is frequently presented by critics of China’s exchange rate policy which creates the impression that China runs a massive trade surplus with virtually the entire world. It is important to understand that the factual situation is the opposite. The trade data produced by the US itself shows that China’s trade has frequently been in deficit with the rest of the world apart from the US, that the surplus in China’s non-US trade which did appear after 2006 is declining rapidly, and that China has almost certainly returned to a situation where its trade with the rest of the world, apart from the US, is once again in balance or in deficit.
It should be again made clear that this situation is clear from US data and does not require acceptance of China’s own data or resolution of the statistical differences between US and China. In the following IMF figures are used for China’s total trade.
China’s trade is in deficit with the rest of the world excluding the US
To understand a difference between widely cited US and Chinese trade figures It should be noted that the most frequently quoted US trade statistics differ from the trade data usually quoted in China in that they exclude indirect trade costs such as transport, insurance etc. – i.e. US data is usually cited on a balance of payments basis whereas China’s statistics are usually cited on a balance of trade basis. Calculated on the US basis Figure 4 shows China’s total trade balance, its trade balance with the US, and China’s balance on non-US trade.
The pattern of China’s trade with the rest of the world, apart from the US, is evident. Until 2006 China ran a deficit on non-US trade. In 2007 and 2008 a surplus appeared - of $57 billion and $93 billion respectively, and in 2009 this again fell to around $15 billion. As China’s trade surplus has continued to fall in 2010 it is almost certain that China’s trade is now once again in balance or deficit with the rest of the world apart from the US.
Figure 4
The geographical distribution of China’s trade
Turning to the more specific geographical structure of China’s trade, US statistics indicate that 76% of China’s exports went to countries other than the US – China’s trade figures show 83% of its exports going to non-US destinations. Calculated from US figures, 94% of China’s imports come from countries other than the US – approximately the same figure as in China’s trade data. In total, even on US figures, 84% of China’s trade is with countries other than the US.
An immediate consequence of the US argument on RMB revaluation is evident from this geographical distribution of China’s trade. The US is proposing to address a bilateral issue, that of the US-China trade balance, with a solution, an increase in the RMB’s exchange rate, which would affect not only the US but all countries. Indeed by far the greatest part of the direct impact of an increase in the RMB’s exchange rate, that is 84% of it, would be outside the US while only 16% would be on trade with the US.
It may also be noted from the graph above that the effect of the increase in the exchange rate of the RMB on China’s balance on non-US trade was much greater than its effect on trade with the US. Between 2004, the year before RMB revaluation commenced, and 2008 the increase of China’s trade surplus with the US was $106 billion. The shift in China’s favour in the balance of non-US trade was however $196 billion – from a deficit of $93 billion to a surplus of $103 billion. This indicates a danger that the short/intermediate term increase in China’s trade balance with countries other than the US which would result from an increase in the RMB’s exchange rate would be great than with the US – creating a potential for widening of trade frictions.
International impact of RMB revaluation
Analysing this quantitative structure of China’s trade, the general effect of an increase in the RMB’s exchange rate on inflation and living standards in other countries may be gauged. RMB revaluation, other things remaining equal, puts up China’s export prices. While the indirect inflationary impacts of such export price increases are difficult to calculate, as they tend to be self-reinforcing, the approximate magnitude of the direct inflationary effect of an increase in RMB prices due to revaluation is evident from this data.
A number of China’s commentators have pointed out that an increase in China’s export prices would reduce living standards and add to inflationary pressure in the US. To put figures on the scale of this effect, China’s exports to the US in 2007-2009 were slightly above 2% of US GDP in each year ($321 billion in 2007, $337 billion in 2008, and $296 billion in 2007). A rough guide to the direct inflationary effects, other things being equal, is therefore that a 10% increase in the RMB’s exchange rate would add 0.2% to US inflation, a 20% revaluation of the RMB would add 0.4% to US inflation etc. Other factors remaining equal, this would translate into a reduction of the same order of magnitude in US living standards. Given that China’s imports are largely in the lower part of the price spectrum, the effect on the least well off US consumers would be greatest.
However due to the relatively low percentage of trade in US GDP the inflationary impact, or put in other terms the effect in lowering living standards, on the rest of the world of an RMB revaluation rate would actually be somewhat greater than for the US.
Assuming China’s exports are priced in dollars, as in the majority of cases, in 2008, the latest year for which full figures are available, China’s merchandise exports to non-US destinations were equivalent to 2.6% of the world’s GDP excluding the US and China. Other things being equal, therefore, the direct effects of a 10% increase in the RMB’s exchange rate would add approximately 0.26% to world inflation, a 20% increase in the RMB exchange rate would add 0.52% to world inflation etc. A 40% increase in the RMB’s exchange rate, as demanded by some in the US, would add in terms of direct effect more than 1% to world inflation. Other factors remaining equal, there would be equivalent reductions in world living standards.
Naturally, given the complex interactions involved in determining inflation and consequent reductions in living standards, these figures on direct effects only give guides to orders of magnitude. But they are sufficient to confirm that the greater part of the effect of any increase in the exchange rate of the RMB would be felt outside the US – inevitably given the geographical distribution of China’s trade. China’s position as the world’s largest exporter means that changes in its exchange rate have a perceptible effect on international inflation and living standards.
It is superfluous to note that such pressures to inflation and reduction in living standards are undesirable – particularly in conditions where the world is recovering from the worst financial crisis for eighty years.
Short term consequences of RMB revaluation
Turning from such structural effects to more short term consequences the latter might be roughly defined as covering a 6-18 month period. Normally it might be possible to ignore such short term effects, but this cannot be done under conditions where the world economy is still recovering from severe financial meltdown.
To evaluate short term consequences it is necessary to recall that China is not only the world’s largest exporter but also its fastest growing importer. Since the outbreak of the international financial crisis, China’s imports have provided the world’s single biggest boost in external demand for other economies.
In annualised terms between July 2008 and December 2009 OECD data shows US imports fell by $550 billion and China’s imports rose by $100 billion, while in the same period the US trade deficit shrank by $364 billion and China’s surplus fell by $180 billion. On an annualised basis the US therefore was subtracting $364 billion from international net demand while China was adding $180 billion.
Since more than half the goods China imports are inputs to exports, a cut in the volume of China’s exports, due to RMB revaluation, would lead to reductions in its imports – evidently hitting countries such as Japan, South Korea, Germany and Australia especially hard.
Furthermore the US explicitly aims to reduce its trade deficit – thereby reducing net international demand. China’s policy is to expand international demand by boosting imports and cutting its trade surplus. A reversal of the trend whereby China’s trade surplus was falling, which would be caused by RMB revaluation, would therefore have an undesirable effect in reducing world external demand.
Growth of imports and domestic economic policy
Finally, as RMB appreciation, that is a movement in the relative price of exports and imports, would for the reasons outlined lead to an immediate increase in China’s trade surplus, therefore, what means are available to reduce the trade surplus? As this cannot be achieved in the short to intermediate term by price changes the answer necessarily has to be found in effects on volumes. Given that reduction in exports is undesirable, as China’s export industries have still not recovered their previous volumes of output prior to the financial crisis, the only workable solution to narrowing China’s trade gap further, as Commerce Ministry spokesperson, Yao Jian stated, is to take "measures to stimulate imports."
This of course occurred during 2009 and 2010 and narrowed China’s trade surplus. The pre-financial crisis peak of China’s exports and imports was reached in July 2008. By March 2010, compared to the pre-crisis peak level, China’s exports had fallen by 18% but its imports had risen by 7%.
Stimulating imports, however, is not primarily a matter of trade delegations – although these are of course useful. It is primarily a function, first, of measures to stimulate domestic demand and second of the rapid growth of China’s economy.
China's imports rose faster than exports in 2009 in major part because its economy grew more rapidly than others. While other markets stagnated or declined, China grew at 8.7 percent, and sucked in imports. The most effective way to maintain the import surge is rapid economic growth.
Inflation and domestic economic policy
At this point trade intersects with domestic economic policy. The most immediate threat to growth in China is inflation. Inflationary capacity constraints have already emerged. Fortunately China's 2009 growth pattern puts it in better shape to deal with inflation than if it had followed some of the advice it was offered from abroad. Many commentators who called for revaluation also favoured expanding domestic consumption, but not investment – citing the threat of "overcapacity". If this policy had been pursued, China would be facing much greater inflationary capacity constraints – threatening economic growth and imports. Happily, China expanded both domestic consumption and investment. The increased capacity that resulted will allow faster growth than would otherwise have been the case, increasing demand for imports.
Mutually beneficial policies
A coherent strategy both from China's point of view and for creating a "win-win" situation with other economies therefore means avoiding an excessively early RMB revaluation. This will allow China's exporters to recover and avoid a short term increase in China's trade surplus. Simultaneously rapid economic growth is not just good for China but also boosts imports. And to make rapid growth possible without inflation China needs to boost domestic investment as well as consumption. Investment, in turn, boosts imports of machinery and equipment. Foreign countries should argue for China to maintain the existing RMB exchange rate in the short run, maintain rapid growth, and, to underpin growth, undertake high levels of domestic investment. This is the combination that will create a "win-win" situation. By contrast, an excessively early RMB revaluation would create a "lose-lose" scenario. It would hit China's exporters, lead to a short term increase in China's trade surplus, withdraw an economic stimulus in a recessionary international economic situation and, linked to reducing investment, would exacerbate inflationary capacity constraints. It may be that other economic considerations, notably the fight against inflation, will force China into a premature increase in the RMB's exchange rate, but from the trade point of view, and that of international economic recovery, this would be undesirable.
Conclusion
Holding the RMB’s exchange rate steady in the short term, while letting it rise in the medium/long term, has so far been the position of China’s government. This seems to have been based primarily on domestic economic considerations. But it also happened to be in the best interests of the world economy.
It may be noted that, of course, trade cannot be the only consideration in setting the RMB’s exchange rate. RMB revaluation may be adopted for reasons such as the struggle against inflation or cooling an overheated economy. These considerations may have to take priority over trade policy. However such decisions should be taken recognising that, in the short term, RMB revaluation will put upward pressure on China’s trade surplus.
Timing
Timing is crucial for the world economy and therefore for RMB revaluation. In the medium to long term evidently the exchange rate of the RMB should and will go up – the increasing productivity of China’s economy makes it competitive at progressively higher exchange rates. But because an increase in the RMB exchange rate would put upward pressure on China’s trade surplus in the short term, from the point of view of world trade it would be better if revaluation did not take place until the world recovery is more firmly established – on current trends likely to be closer to the end of this year.
Appendix – a note on some false arguments by foreign critics of China’s exchange rate policy
In the paper above a number of serious arguments relating to RMB revaluation have been dealt with. It should, however, be noted that a number of simply false claims regarding China’s trade are made by international critics. Two of these, notably that by the influential US economist Paul Krugman, who called for US trade action against China in a New York Times column which has been widely quoted, are therefore dealt with here.
Paul Krugman’s erroneous claim
It was analysed above that China’s trade with the rest of the world, apart from the US, has frequently been in deficit and has probably passed back into balance or deficit in 2010. It may be noted from this reality why some critics make false and exaggerated claims regarding the size of the China’s surplus – a statement of the actual facts would reveal the actual situation that China has not typically, and is not currently, running a surplus in non-US trade. For example Paul Krugman, talking about China’s balance of payments, including service and investment income as well as trade, in his New York Times column claimed that ‘the International Monetary Fund expects China to have a 2010 current surplus of more than $450 billion.’
Of course if China were factually running a $450 billion dollar balance of payments surplus this is sufficiently large it would entail that a trade surplus was being run not only with the US but with the rest of the world. No source is given but if any IMF statistician made such a claim it is inaccurate – as Krugman could have found out by checking the figures.
Once China’s balance on services and income is included, and the standard statistical correction for carriage and insurance made, China’s annual balance of payments surplus is about $120 billion over its unadjusted trade surplus. The latter was $198 billion in 2009 and falling – in the 12 months to February 2010 it was $180 billion. Therefore there is no way China’s balance of payment surplus will reach anything like $450 billion this year. The actual falling trend of China’s trade surplus is shown in Figure 5.
Figure 5
To take a similar example, the British economist Will Hutton claimed in The Observer that China is ‘increasing its reliance on exports.’ Again this is factually false. China’s exports declined to 25 percent of GDP in 2009 from 35.7 percent in 2006 – as shown in Figure 2. In reality the increase in China’s domestic demand has led to a sharp decline in the weight of exports in China’s GDP.
Figure 6
