A Breakthrough on the Renminbi?
There are encouraging signs that a breakthrough may have been achieved in the long-running debate over the exchange rate of China's currency, the renminbi. Its real rate against the dollar is now rising at an annual rate of 10 to 12 percent, which if continued would complete the needed correction of 20 to 30 percent over two to three years, and official US reactions suggest that assurances that the adjustment will continue may have been received. This movement appears to derive from effective US pressure, increasing expressions of concern about the issue from other countries (especially a number of major emerging markets) and, most importantly, changes in economic conditions in China itself.
The nominal exchange rate of the renminbi has now appreciated by about 3.7 percent against the dollar since China announced last June that it would let the rate start moving upward again. During this same period, Chinese inflation has accelerated and is running substantially above that of the United States (which is less than 2 percent). Different indexes produce different results and all of the official numbers probably underestimate the actual pace of upward price movements in that country. It is safe to say, however, that the real exchange rate of the renminbi has risen by at least 5 percent against the dollar over the past seven months, producing a real appreciation against the dollar at an annual rate of at least 10 percent and perhaps as much as 12 percent.
China continues to intervene against the dollar to limit its appreciation, however, and the dollar has declined against most other currencies during this same period. Hence the trade-weighted average exchange rate of the renminbi has not appreciated by much. This "real effective exchange rate," or REER, should be the focus of our attention since the goal should be a sharp reduction in China's global current account surplus rather than solely its bilateral surplus against the United States.
We must recognize, however, that the Chinese themselves continue to focus almost wholly on the dollar rate and that US officials, and especially Congressmen, often do so as well. We must also recognize that calculation of REERs is technically complex, because agreements would have to be reached on appropriate measures of inflation in both China and the rest of the world (the "real" component) as well as on the weighting of other currencies (the "effective" component); it is much simpler, especially in working out international agreements on the issue, to focus on the nominal bilateral rate. It is also true the dollar may rise as well as fall over the coming period, and that, if recent history is any guide, the Chinese will "ride it up" just as they have recently "ridden it down." But lasting adjustment will not be achieved until the REER for the renminbi, as well as its bilateral rate against the dollar, has appreciated adequately and permanently.
What is a reasonable goal? In testimony before the Senate Banking Committee last September, Secretary of the Treasury Tim Geithner implicitly endorsed an objective that I had proposed shortly before: that China replicate, over the next two to three years, the real effective appreciation of 20 to 25 percent that it permitted between 2005 and 2008. This implies a somewhat higher appreciation, of perhaps 30 percent, against the dollar. We thus need assurance that the renminbi will rise against the dollar by about 10 percent annually, the pace that has now eventuated since last June.
Why has China moved now? First, the United States has clearly escalated its pressure in a series of private conversations over the past six months while respecting China's obsession with avoiding the appearance of capitulating to public admonitions. President Obama reportedly placed highest priority on the currency issue during his extensive bilateral conversation with President Hu Jintao around the G-20 summit in Seoul in early November. This took place after the US mid-term elections so it could not be interpreted by the Chinese as "simply playing domestic politics in the United States." China was clearly taken aback by the strong US criticism of a number of their policies over the past year, ranging from their naval activities in the South China Sea to their passivity regarding North Korea to a range of new trade and industrial policy issues, and recognized that resolving the currency issue was a key element to restoring comity in the overall relationship, which is of great importance to them.
It is not difficult to imagine that an implicit or explicit deal was struck at the private dinner between the two Presidents on the first day of Hu's visit to Washington in mid-January: China will continue to let its exchange rate rise at the needed pace while the United States will avoid public commentary on the issue. The deafening silence from the US side throughout the visit, which has continued through subsequent events such as the World Economic Forum in Davos, supports such speculation. So does the subsequent Treasury report on foreign exchange issues, released on February 6, which could only exonerate China from designation as "manipulating" its currency on the basis of such an expectation. The two governments may not yet have created a fully functioning G-2, of the type I proposed over five years ago to provide an informal steering committee for the world economy, but the two Presidents have met eight times over the past two years and routinely discuss the entire range of global as well as bilateral issues; a resolution of the currency conflict would mark a major success for that process.
It is noteworthy that the actual jumps in the renminbi since last June correlate closely with episodes of US pressure: in early September in the run-up to major hearings on the issue in both the House and Senate, in early October when the Senate was considering whether to take up the China currency bill that the House passed on September 30, in early November prior to the G-20 summit, and from mid-December through mid-January as President Hu prepared to travel to Washington.
A second factor was the increased expression of concern over the renminbi issue by other countries, especially key emerging markets. France, the new chair of the G-20, has been extremely pointed on the topic behind closed doors. Central bank governors from Brazil and India have spoken publicly on it, and private criticism from those countries, and very sharply from others such as Mexico, has recently increased. Of particular importance may be the growing entreaties from other Asian countries, including a number of China's neighbors, who have seen their exchange rates rise considerably more than China's over the past half year.
Conditions inside China are presumably the most important factor in the authorities' decision to let the renminbi rise significantly. Inflation has replaced growth as the leading concern for economic policy and a stronger currency in a very open economy like China's is one of the most effective instruments to counter surging prices (and for the central government to impose its will on often-recalcitrant provisional governors). Growth itself continues at near double-digit levels and, with the high probability of reasonably robust expansion in the US and world economies for 2011 and beyond, the authorities can now be confident that China will not suffer a relapse even if its trade surplus declines a bit. They also observe that their economy continued to grow prodigiously throughout the earlier period of renminbi appreciation in 2005–08, tempering fears that the inevitable adjustments will be excessively painful. China's evident desire to increasingly internationalize the renminbi may also tilt it toward reducing its intervention and letting the exchange rate move toward an equilibrium level.
The Chinese authorities have of course reiterated their intent to rebalance their economy, away from exports and the underlying investment in capital-intensive industries, for a number of years and have made commitments to the G-20 to do so. They have indeed imbedded that concept in the new five-year indicative plan that is scheduled to begin next year. They have apparently, and correctly, concluded that this is the perfect time to accelerate the adjustment process with inflation the new priority at home while unemployment remains of paramount concern in the United States and Europe, their two main trading partners.
It is of course impossible to know how durable any such agreement might turn out to be. The United States and the world as a whole will have to monitor renminbi developments closely and regularly. The US government will have to continue its private pressure and the Congress will have to maintain the prospect of renewed legislative initiatives if progress falters. In doing so, however, everybody must recognize that the rate will not rise monotonically because, as they have done since last June, the Chinese will want to keep speculators guessing by engineering periodic depreciations for a few days or even longer.
We must also have no illusion that the Chinese are letting market forces determine the rate. They will continue to intervene heavily and simply manipulate it to a stronger level that is both more beneficial to their own economy and more compatible with global equilibrium. In light of the gradual pace of appreciation, and the lags of two to three years between currency moves and trade results, we must also recognize that China will continue to run sizable (if falling) external surpluses for at least another five years (and thus keep buying more Treasury bills, albeit hopefully at a declining rate).
The postulated outcome, a rise of 20 to 30 percent in the renminbi over two to three years, would have major positive effects. China's global current account surplus would drop by $300 billion or so from the rising path that it would otherwise be on, and retreat well within the unofficial norm of 4 percent of GDP that has been discussed by the G-20 and endorsed by some Chinese officials. The US external deficit would drop by $50 billion to $100 billion, creating perhaps 500,000 new and high-paying jobs (mainly in export industries) in this country. We know that currency changes produce these powerful results because the earlier rise of the renminbi during 2005–08 and the 25 percent fall of the dollar during 2002–07, along with the global recession, produced declines (with the usual lags) of fully one half in both countries' imbalances by 2009 (before they started rising again last year because the currency corrections halted or reversed). The world's only major currency misalignment would be largely corrected, and the outlook for world growth and global finance would become much stronger and much more sustainable.