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Why the Yuan is Still Way Too Cheap
Alan Tonelson
Thursday, October 25, 2012
Photo of Alan Tonelson
Alan Tonelson is a Research Fellow at the U.S. Business & Industry Educational Foundation and the author of The Race to the Bottom: Why a Worldwide Worker Surplus and Uncontrolled Free Trade are Sinking American Living Standards (Westview Press).
Both pseudo and real economists have a long record of conveniently forgetting the discipline’s fundamental precepts where trade and globalization issues are concerned.  Thus such analytical gems as the claims that:

>export increases alone enable trade flows to boost growth and employment (in fact, those results can only be credited to trade when balances improve);

>national savings shortfalls cause trade deficits (in fact, the broadly accepted mathematical relationship between the two is an identity, which says nothing about causation); and that

>greatly increasing the worldwide supply of labor available to multinational firms through new trade agreements couldn’t possibly undermine the price commanded by competing American labor.

This week, this shabby tradition has continued with widespread claims that China is no longer manipulating its currency – at least not enough to justify a Mitt Romney-style response that would call Beijing on the carpet, if necessary, impose offsetting tariffs.  New York Times columnist Paul Krugman (a Nobel Prize winner), announced in an October 22 blog posting that since the yuan has recently strengthened against the dollar, it’s no longer deliberately being grossly undervalued.  Thus the issue no longer deserves the spotlight.  Meanwhile, President Obama and his top aides have been making this argument for months, and portrayed the yuan’s recent rise as proof that their quiet currency diplomacy has worked, and that legislative responses like the Senate-passed anti-currency manipulation bill were therefore never necessary.

These claims sound eminently reasonable, given that the yuan has appreciated by about 24.50 percent against the dollar since Beijing initially loosened the dollar peg in June, 2005, and by some 8.63 percent since the President took office in January, 2009 (through October 19).

But here’s the obvious, elementary economic maxim that’s being overlooked in the rush to exculpate China:  Changes in an exchange rate per se have no intrinsic bearing on the issue of undervaluation.  More specifically, even a strengthening currency can remain substantially undervalued.  Indeed, it can even be increasingly undervalued -- which the soundest analysis is telling us is exactly the situation with the yuan.

After all, an exchange rate simply shows how much of a particular currency is needed to buy a unit of another currency.  Whether a currency is freely traded or not, the exchange rate and any movements in such rates are simply objective, observable facts and trends.  

When free markets are calling the shots, these currency values and their changes usually reflect how investors view the relative strength and competitiveness of the two economies in question, and their future prospects, at any particular moment.  Of course, traders buy and sell currencies for all sorts of reasons only loosely connected with economic fundamentals – especially in the near term.  But over longer stretches, currencies generally strengthen because investors are increasingly impressed with those fundamentals or where they’re supposedly headed, and weaken when investors reach the opposite conclusion.

But whereas terms like ”strong,” “strengthening,” and  “appreciating” (or ”weak,” “weakening,” and “depreciating”) describe currencies’ actual positions and movements in the markets, terms like “undervaluation” (and “overvaluation”) mean something very different.  They refer to ultimately subjective judgments that a given exchange rate does not accurately reflect economic fundamentals – as opposed to a properly valued exchange rate, that supposedly does reflect them.   In everyday terms, undervalued and overvalued currencies are currencies that over some stretch of time are either lower or higher than they “should be.”  

Yuan hawks and doves agree that China’s currency has strengthened in recent years – not surprising, since the numbers are undeniable.  There’s also apparently widespread agreement between them on the judgment that China’s currency was undervalued for years.  In other words, they acknowledge that the yuan’s value in dollars was much lower than the economic fundamentals indicated.  Most also seem to attribute this undervaluation to the Chinese government’s desire to reap the trade advantages of artificially inexpensive goods, not to the kinds of misjudgments markets make frequently (most often over the short term).

The remaining and crucial disagreement centers on the judgment call of proper valuation in recent months.  According to their recent writings, yuan doves believe that this currency’s appreciation has also significantly reduced undervaluation and brought the currency significantly closer to appropriate valuation.  But the only three possible intellectual bases for this conclusion are fatally flawed.  

First, the doves could be simply equating movements in exchange rates with movement toward more appropriate valuations.  I.e., the doves are mistakenly convinced that simply because the yuan is strengthening, it’s ipso facto becoming more properly valued.  That possibility, however, appears unlikely considering the blue-chip intellectual credentials most of these observers sport.  

Second, the doves could believe that, since Beijing loosened the yuan-dollar peg for the first time more than seven years ago, the proper measure of appropriate valuation for the currency today is whether it reflects the competitive balance between the United States and China back in mid-2005 (or at whatever baseline they wish to use).  Again, this seems unlikely.  The doves surely know that the national economic fundamentals used as currency yardsticks comprise constantly moving targets for those seeking to determine appropriate exchange rates (because national economies are changing constantly).  

This means that the valid measure for the yuan’s appropriate value versus the dollar today is the competitive balance between the two countries today.  Similarly, the measure to use for judging how much progress the yuan has made toward this appropriate valuation is the change in the two economies’ relative competitiveness since mid-2005 (or since whatever baseline period is used.)

Third, in that vein, the doves could recognize the need to hit a moving target.  But they could also believe that, since mid-2005, the yuan has been rising faster versus the greenback than China’s entire economy has been strengthening vis-a-vis America’s entire economy.  Alternatively, they could even believe that the yuan has been rising even though China has been losing ground economically to America during that time.  

This view that the yuan’s strengthening has outstripped the entire Chinese economy’s improvement relative to America's is defensible in principle.  To simplify, it entails the conviction that, if the yuan has appreciated by some 24 percent versus the dollar since mid-2005, the Chinese economy has improved by less than that 24 percent versus America’s during this period.

But although the Chinese economy appears to have encountered notable problems over the last year, its improvement vis-à-vis America has actually accelerated during the last half decade according to nearly all the metrics relied on by currency investors – including growth rates, productivity rates, and even current account balances.  The blackest mark by far on China’s recent record – worrisome inflation in 2010 and 2011 – has subsided this year as growth has cooled.  A major reason, of course, for China's relative gains is that the United States has experienced a nearly catastrophic financial crisis, a painful recession, and an agonizingly incomplete recovery, whereas China has not.  

In fact, considering the dramatic contrast between America’s economic performance and China’s since 2005, it’s entirely possible that the yuan has strengthened more slowly versus the dollar over the last half decade than the competitiveness of the Chinese economy improved (i.e., the latter’s overall position versus America has improved by much more than the illustrative 24 percent).  

The upshot would then be that even though the currency has strengthened against the dollar, it is now even more undervalued than it was in 2005.  For the Chinese economy’s dramatic progress since the peg was loosened has driven the yuan nowadays even further below where it “should be” than it was back then.  As a result, a fairly valued Chinese currency today would be much stronger versus the dollar than it has become, and had it been freely traded in recent years, a major rise would have begun much sooner.

It’s clear enough why the Obama administration has embraced the claim that the undervaluation problem is largely solved.  This position justifies continued inaction against a production and export subsidy that benefits the U.S. multinational outsourcers that manufacture in China and whose interests are still permitted to dominate American trade policymaking.  But the scholars, other so-called experts, and pundits who have swallowed this Kool-Aid – what’s their excuse?  



Alan Tonelson is a Research Fellow at the U.S. Business & Industry Educational Foundation and the author of The Race to the Bottom: Why a Worldwide Worker Surplus and Uncontrolled Free Trade are Sinking American Living Standards (Westview Press).
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