Chinese Yuan vs. the US demand - Economics Theory

The conventional wisdom is that once the value of the Chinese Yuan is increased, the USA’s trade deficit with China would start falling. This reasoning has prompted many Americans to push for further, faster revaluation of the Yuan even after China changed its currency policy.

For those who endorse this rationale, the Yuan’s value is a paramount factor behind China’s, and their country’s trade balances.

But for John Ross, former deputy mayor of London in charge of economic and business policy, the trade gap between a country and China would widen instead of narrowing down, at least in the short term, if the Yuan’s values go up.

Mr. Ross, a visiting professor at Antai College of Economics and Management in Shanghai Jiaotong University, says that once the Yuan’s value rises the Americans would demand further revaluation, ultimately forcing the Yuan to rise to a level that would not only disrupt China’s trade and economy, but also pose a threat to the entire World’s economy.

Moreover, the number of jobs in the US would not increase unless the federal government changes its economic policy and raises investments, which is the real solution to its problem. Pressuring China to raise the Yuan’s value sharply will not help. “Most people, particularly those abroad, don’t know the real situation. The reason they want the Yuan to be revaluated further is because they think it would reduce China’s trade surplus, this is simply not true.”

From what happened between Y’s 2005 and 2008, when the Yuan rose 21% against the USD, it’s clear that China’s “trade surplus rose, too”, Ross said. Any revaluation of the Yuan raises the price of exports and reduces the price of imports, which means China’s trade surplus would get bigger as its currency rises.

By examining historical data, Ross has found that China’s exports and imports grew simultaneously after Y 2005 in terms of volume, but the prices of exports rose more relative to import thanks to the revaluation of the yuan. “That’s why its trade surplus with the USA is bigger today.”

There’s a big debate among economists over what would happen in the long term if the Yuan rose further, he says. Some people think China’s trade surplus would increase, while others think it would fall in the long run. “But there’s no difference in what they say would happen in the short term.”

Seen from the history of US trade, its overall trade deficit rose at nearly US$70B a month until Y 2006, he says. Then it stabilized before rising again after the passage of the worst period of the Global financial crisis. “That’s why the American people are getting agitated because it has worsened, but it is not rising because of China, for, I’m using US figures, not Chinese figures, the trade surplus of China with the US is rather stable, slightly under US$20B a month.”

In other words, claiming that the trade deficit of the US is rising because of China is simply not true, he says. “It’s because its America’s trade deficit with the rest of the world is rising, too.”

The US has a trade deficit with about 90 countries. “If you reduce its trade deficit with China, all that would happen is that its trade deficit with some other country would increase.”

US hawks, however, have always targeted China and pressured it to dance to the tune of their demand. Even if China has pledged to make the yuan more flexible by reforming its exchange rate mechanism further and peg it to a basket of currencies to better reflect the demand of the market, some US politicians and industrial leaders say it’s “too little too late” and demand the Chinese currency be revaluated by up to 40 percent.

Forcing the value of the yuan to rise would cause further uncertainties in the world economy, which today faces other big challenges such as the European Union debt crisis. “We are not (living) in a normal stable economic environment; we are just about recovering from a very bad financial crisis and what happens in the next 6 to 18 months is very important and would have a very big effect,” he says. “The last thing the world needs at present is a short-term increase in China’s trade surplus because of an increase in the value of the yuan.”

Rethinking the Global Money Supply - Economics Theory

The People’s Bank of China jolted the financial world in March with a proposal for a new global monetary arrangement. The proposal initially attracted attention mostly for its signal of China’s rising global economic power, but its content also has much to commend it.

A century ago almost all the world’s currencies were linked to gold and most of the rest to silver. Currencies were readily interchangeable, gold anchored exchange rates and the physical supply of gold stabilized the money supply over the long term.

The gold standard collapsed in the wake of World War I. Wartime financing with unbacked paper currency led to widespread inflation. European nations tried to resume the gold standard in the 1920s, but the gold supply was insufficient and inelastic. A ferocious monetary squeeze and competition across countries for limited gold reserves followed and contributed to the Great Depression. After World War II, nations adopted the dollar-exchange standard. The U.S. dollar was backed by gold at $35 per ounce, while the rest of the world’s currencies were backed by dollars. The global money stock could expand through dollar reserves.

President Richard Nixon delinked the dollar from gold in 1971 (to offset the U.S.’s expansionary monetary policies in the Vietnam era), and major currencies began to float against one another in value. But most global trade and financial transactions remained dollar-denominated, as did most foreign exchange reserves held by the world’s central banks. The exchange rates of many currencies also remained tightly tied to the dollar.

This special role of the dollar in the international monetary system has contributed to the global scale of the current crisis, which is rooted in a combination of overly expansionary monetary policies by the Federal Reserve and lax financial regulations. Easy money fed an unprecedented surge in bank credits, first in the U.S. and then elsewhere, as international banks funded themselves in the U.S. money markets. As bank loans flowed into other economies, many foreign central banks intervened to maintain currency stability with the dollar. The surge in the U.S. money supply was thus matched by a surge in the money supplies of countries linked to the U.S. dollar. The result was a temporary worldwide credit bubble, followed by a wave of loan defaults, falling housing prices, banking losses and a dramatic tightening of bank lending.

China has now proposed that the world move to a more symmetrical monetary system, in which nations peg their currencies to a representative basket of others rather than to the dollar alone. The “special drawing rights” of the International Monetary Fund is such a basket of four currencies (the dollar, pound, yen and euro), although the Chinese rightly suggest that it should be rebased to reflect a broader range of them, including China’s yuan. U.S. monetary policy would accordingly lose its excessive global influence over money supplies and credit conditions. On average, the dollar should depreciate against Asian currencies to encourage more U.S. net exports to Asia. The euro should probably strengthen against the dollar but weaken against Asian currencies.

The U.S. response to the Chinese proposal was revealing. Treasury Secretary Timothy Geithner initially described himself as open to exploring the idea; his candor quickly caused the dollar to weaken in value—which it needs to do for the good of the U.S. economy. That weakening, however, led Geithner to reverse himself within minutes by underscoring that the U.S. dollar would remain the world’s reserve currency for the foreseeable future.

Geithner’s first reaction was right. The Chinese proposal requires study but seems consistent with the long-term shift to a more balanced world economy in which the U.S. plays a monetary role more coequal with Europe and Asia. No change of global monetary system will happen abruptly, but the changes ahead are not under the sole control of the U.S. We will probably move over time to a world of greater monetary cooperation within Asia, a rising role for the Chinese yuan, and greater symmetry in overall world monetary and financial relations.

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