Meaningless Fervor Over China's Exchange Rate Policy

We would all be better served if more journalists and politicians chose to avoid discussing currency exchange rates. This is particularly true when it comes to the current value of the Chinese yuan -- Beijing's domestic currency that is presently pegged to the dollar at an exchange rate of 6.83 yuan to every greenback. This exchange rate has been in effect since July 2008 and has become the latest target for amateur economists seeking to explain why Americans purchase so many items assembled or manufactured in China. According to these pundits, Beijing's decision to adhere to this fixed exchange rate explains our trade imbalance with China and an immediate end to this practice will abet the revival of relatively unskilled manufacturing in America. Phooey.

We've been down this exchange rate path before ... and the pundits were as wrong then as they are now. As Patrick Chovanec so ably notes in an item posted on Seeking Alpha, the "learned" economists favored on Capitol Hill made similar claims about Japan's yen in the early 1980s. Confronted with a significant trade imbalance that worked in Tokyo's favor, central bankers in Washington, Tokyo, Paris, London and Berlin sought to drive up the value of the yen by 50%. It took two years, but by late 1987 the yen increased in value from an exchange rate of around 250 to a dollar -- to approximately 125 to a dollar. Know what happened to the trade imbalance ... you guessed ... Japan's trade surplus with the United States actually grew.

Now step 20 years into the future. Between 2005 and 2008 China allowed the value of the yuan to appreciate 21%. That is two say, over an approximately two year period the yuan increased in value from 8.28 to $1.00 (an exchange rate that had been in effect since 1996) to the current 6.83 to $1.00. Know what happened to the Sino-U.S. trade imbalance? Yup, it grew. Seems we had not learned a damn thing from our previous experience with Japan. In fact, if you look at the rhetoric surrounding President Obama's current trip to Asia one could swear we had returned to 1985. All you have to do is swap "China" for "Japan" and "yuan" for "yen." George Santayana was right, "Those who cannot learn from history are doomed to repeat it."

But such niceties are rarely given heed when politicians are pandering to public opinion. A case in point -- Treasury Secretary Geithner's remarks to CNBC on Nov. 12. Speaking with reporters, Geithner declared a more flexible yuan "is important for China, important for the region, important for the world economy." The Chinese -- unsurprisingly -- were not amused with Mr. Geithner's economic moralizing. On Nov. 15, a spokesman for China's Ministry of Commerce offered a very blunt criticism of Washington's hypocritical finger-wagging. To quote the Chinese spokesman, "We recently saw media comments saying that [yuan] appreciation should accelerate, but we note that the dollar has depreciated, which has improved U.S. export competitiveness. We don't think that it's good for the world economic recovery that you ask others to appreciate while you depreciate your own currency." Touche.

Ok, so maybe it's not fair to allow a Chinese government spokesman to criticize Geithner. (Of course this begs a discussion of exactly how we should characterize a treasury secretary who spends as much time talking to reporters as Geithner does -- but that's a topic for another occasion.) Instead, let's see what an arguably less biased source has to say about the current value of the Chinese yuan. Justin Yifu Lin currently serves as the World Bank chief economist. A former resident of Taiwan who defected to the mainland in 1979, Mr. Lin has a doctorate in economics from the University of Chicago. Lin's thoughts: A significant appreciation in the yuan's value could snuff out the global economic recovery; such a move would further depress U.S. consumer activity; and ... here's the painful part for Washington ... would not reduce the U.S. trade deficit with China because most of what Americans purchase from Chinese firms is no longer manufactured in the United States.

Houston, we clearly have a problem. How do we go about addressing the issue? First, the inflammatory rhetoric needs to stop. Second, as Mr. Lin observes, structural reforms are required both in Washington and Beijing. Washington needs to get our economic house of cards back in order -- by, oh say, not continuing to expand our national debt at breakneck speed. Beijing needs to reduce China's savings rates and increase domestic consumption.

This, of course, begs the question of who should go first -- Washington or Beijing. I'm thinking the first move is to be made back here in the U.S. of A. Turns out the Chinese decision to peg the yuan to the dollar has become a very clever move, particularly in light of the greenback's continuing depreciation. Over the last year the dollar has been in steady decline, and the yuan has gone down the same path. The result is evident when you consider that since March 2009 the South Korean won has gained 8% against the yuan, the Japanese yen has risen 6%, and the same can be said for fate of the Indian rupee. Why would the Chinese allow the yuan to appreciate in value when Beijing can claim the real explanation for the currency's exchange rate is to be found in Washington's poor fiscal management? And what American politician would buck a similar trend, particularly if the existing system was promoting job development by enhancing the attractiveness of our exports? My bet is the answer is somewhere between zero and none.

I would note, by the way, that I am not alone in coming to such a conclusion. On Nov. 12, Goldman Sachs announced there would be no change in its 3, 6 and 12 month forecast that the yuan would remain pegged at 6.83 to the dollar. Morgan Stanley appears to be using the same sheet music. On Nov. 14, Morgan Stanley's chief Asia economist told the Telegraph, "Our long-standing view on this issue remains unchanged. While we believe an exit from the current regime of a de facto peg against the dollar may occur in the second half of 2010, any subsequent yuan appreciation against the dollar is, in our view, likely to be modest and gradual."

In other words, the financial bastion of American democracy does not believe our politicians are going to undertake a serious effort to change China's exchange rate policy -- nor do they believe Beijing is going to unilaterally engage in such an effort. So what we are really getting in this barrage of verbiage about China's fixed exchange rate is a heady dose of smoke and mirrors. President Obama is not going to push our primary foreign creditor into change -- and Beijing is betting Washington will continue to spend in a manner that ultimately benefits Chinese exporters and their employees. My final observation -- it's safe to ignore and remain ignorant about this whole exchange rate tempest -- nothing of use or significance is going to happen in the current teapot.