Three Misconceptions Regarding China’s Currency Policy

Zhou Xiaochuan, governor of the People’s Bank of China, used an appearance at the National People’s Congress to give the clearest indication in months that Beijing is preparing to abandon the peg to the US dollar that it informally introduced in mid-2008. He told a press conference that the currency peg was a “special measure” to help China weather the financial crisis. “These kinds of policies sooner or later will be withdrawn,” he said.

The National People’s Congress, which began on Friday, March 5 and runs through March 14, brings together around 3,000 delegates from provincial parliaments, the ranks of the armed forces and Hong Kong, Taiwan and Macau.

Predictably, the PBOC Governor’s comment touched off a flurry of written and verbal commentary on the subject of China’s currency policy. In reading the articles and listening to the interviews, it seems to me that there are three general misconceptions on the subject.

Misconception #1: China Keeps the Value of the Yuan Low to Maintain Its Export Competitiveness

As compelling as this explanation may be to some, I believe it’s far too simplistic, and that in fact, China’s policymakers take into account several factors when determining the country’s currency policy. The impact of any change in currency policy on export competitiveness is certainly one, but China must also be mindful of the effect its currency policy may have on the large amount of dollar-denominated assets which the country now holds. In this regard, I believe that China looks very closely at the relationship between the dollar and the Euro, the two currencies that account for a significant portion of its international trade, and tries to maintain a balance between the two. I don’t think it is mere coincidence that China re-instituted the peg to the dollar in July, 2008, providing important support when the dollar was at a five-year low against the Euro.

Misconception #2: Revaluing the Yuan Will Reduce China’s Trade Surplus With the United States

The empirical evidence does not support the notion that a revaluation of the yuan against the dollar will reduce China’s exports to the United States. In 1985, the exchange rate between the Japanese yen and the US dollar was 250 to 1. Yielding to political pressure from the United States, the yen was allowed to double in value over the next three years, to the point where by 1988, one U.S. dollar could only purchase 121 yen. What did exports from Japan to the United States do during this period? They increased from $69 billion to $90 billion.

Similarly, when China released the yuan from its dollar peg in July 2005, the yuan increased in value by 21 percent against the dollar over the next three years. What did China’s exports to the United States do during this period? They increased by 40 percent from $163 billion to $233 billion.

In both cases, a more highly-valued currency meant that Americans paid more for the goods which they did import, and my guess is that the composition of exports from Japan and China to the United States also changed. Exporting goods with more raw material content, for example, might more than offset higher relative labor costs because raw materials can be purchased more cheaply with a more valuable currency. In the case of China, a more highly-valued yuan has caused exporters to move to higher value-added products where labor content is much less a factor.

Misconception #3: China Will Yield to Political Pressure to Change Its Currency Policy

As the November elections near, and concerns about unemployment in the United States increase, calls for President Obama to “get tough” with China on its currency policy and to label the country a “currency manipulator” will become deafening. Anyone with any experience in China, however, knows that this will only delay any decisions the Chinese government might make to alter currency policy. Simply put, no Chinese leader wants to be seen as yielding to outside pressures on this issue.

Many analysts predict that China will once again allow the yuan to begin a gradual revaluation against the dollar by mid-year. If the dollar continues to gain ground against the Euro, I believe that China will release the dollar peg sooner rather than later.

U.S. politicians would be wise to stay quiet and let events play out.

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