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Is the Chinese Yuan undervalued?
Dr. Hwa Erh-Cheng
11/15/2003



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Whether the renminbi should appreciate has been a hotly debated issue in the international financial media in recent months. This attests that the renminbi matters not only to the Chinese economy but also to the global economy.

The story begins with the US' steadily worsening current account deficit, which is now worth more than 5 percent of GDP, while countries in Asia and Europe enjoy sizable trade surpluses. History suggests that any country with a deficit as large as this would sooner or later suffer a currency crisis or a sharp devaluation. The US economy is the anchor of the world economy and the US is not just another country in the world. Even so, the US dollar began to devalue early this year against a basket of currencies (in both nominal and real effective exchange rates), and the devaluation is likely to continue in the future, narrowing the US trade deficit. However, the robust intervention by Asian central banks to support the dollar, with Japan being the best example, have prevented the dollar from depreciating, leaving the international economy unbalanced. This is why the G7 called for more flexible Asian exchange rates, or more bluntly, to allow Asian currencies to appreciate against the US dollar.

China, with its currency pegged to the dollar and rapidly growing foreign exchange reserves, was obviously one target of this appeal. However, the real pressure on the renminbi has come from the US as it runs a large and fast-growing trade deficit with China that exceeded US$100 billion, or nearly one-fifth of US global current account deficit. Worse still, this occurred in an environment of a jobless recovery in the US economy. With the US presidential election coming next year, it is not unthinkable that the renminbi issue will escalate into a significant Sino-US trade dispute. Already a New York Democratic senator has proposed a draft resolution in Congress calling for the imposition of a 27.5 percent import tariff on Chinese imports.

But is the Chinese currency grossly undervalued, as alleged? Even if it is, could a revaluation of the Chinese currency alone reduce the US current account deficit or help reduce the global economic imbalance significantly?

A recent paper attempted to explain the long-term determinants of the real exchange rate of renminbi, such as the relative productivity differential between countries, the terms of trade and so on, and to assess whether the renminbi is undervalued. However, the author omitted one important factor that accounted at least partly for the sharp real depreciation in the exchange rate in the 1980s and the early part of the 1990s: namely, the steady and significant decline in the level of trade protection. In any event, this approach did not throw much light on the key question: Is the renminbi undervalued or overvalued? Later in the analysis, the author resorts to the "market view," namely that "the pressure on the renminbi to appreciate is apparent" because of "the dual surpluses in the current account and capital account," as well as "an influx of hot money seeking capital gains in case the renminbi is allowed to appreciate."

But the "market view" has its flaws, since China has a very restricted foreign exchange market. In this case, the equilibrium exchange rate is hard to assess, and without a solid benchmark the task to assess whether the currency is undervalued or overvalued seems impossible. At present, trade restrictions remain even though China has attained "convertibility" in the current account, but the capital account is largely "non-convertible." For instance, Chinese citizens cannot legally convert their massive holdings of yuan-denominated deposits into foreign-currency-denominated assets. China's large balance of payments surplus, around 6 percent of GDP last year, appears substantial, but if China were to liberalize capital controls tomorrow and if Chinese citizens went on a stampede to buy US dollar-denominated assets for the sake of asset diversification, the dollar might well appreciate further. If so, can we argue today's renminbi is overvalued?

Another way to address this issue is to look at the size of China's current account surplus in terms of the size of the economy, for the current account mirrors the structural balance or the lack thereof in the economy. For instance, a large current account surplus may indicate excessively low investment/high savings rate, or low spending/high production, or an excessive concentration of the economy's resources on traded goods at the expense of non-traded goods. It also points to a low utilization of domestic resources by exporting resources to foreign countries. If the large current account surplus/deficit were only temporary, it would not create significant problems for the economy. It is the persistent deficit or surplus that is a worry. Judging from this yardstick, China does not seem to run a grossly imbalanced economy. The current account deficit was in the range of 1 percent to 2 percent of GDP in recent years. It did not climb to over 2 percent until last year.

The above analysis suggests that the appropriate approach for China to ease the balance of payments pressure and avoid its potential inflationary consequences is to further liberalize foreign trade and ease foreign exchange controls while discouraging speculative capital inflows. The liberalization of foreign exchange transactions should also create the conditions for China to move to a more flexible exchange rate.

Finally, while more flexible Asian currencies should aid adjustments in the value of the dollar, US should also control the bulging fiscal deficit over the medium term. Faster growth in Europe and in Japan can also help the global economic rebalancing.

*Dr. Erh-Cheng Hwa is an economist at Shih-Hsin University.

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