China-U.S. Trade Imbalance and RMB Exchange Rate

China-U.S. Trade Imbalance and RMB Exchange Rate

 (By Xu Hongcai, Presentation at the Munk School of Global Affairs

At the University of Toronto, on April 30, 2012)

Good afternoon, ladies and gentlemen:

It is my great honor and pleasure to be here today at the University of Toronto and to be in front of you, experts with worldwide influence. My name is Xu, Hongcai. Firstly, I want to thank Dr. Yves Tiberghien for his recommendation that gives me this chance to share my ideas with you. I am now working at China Center for International Economic Exchanges (CCIEE), which is one of most important think-tanks in China.

My presentation today is “China-U.S. trade imbalance and RMB exchange rate”. This is an interesting issue and a complicated issue. My presentation is consisted of seven parts. Part one is introduction. In Part two, I will discuss the reasons for China-U.S. trade imbalance. Part three is about some views on RMB exchange rate. In Part four, I will talk about the reform of RMB exchange rate regime. Then in Part five, I will propose three solutions for China-U.S. trade imbalance. Finally, I will analyze the U.S.’ challenges and proposals in Part Six，and China’s challenges and reforms in Part Seven.

Part One: Introduction

In the past couple of years, China has been criticized by some Congressmen of the United States for “manipulating” its currency in order to maintain its advantage for exports, and thus preserve its trade surplus. A popular view argues that China's trade surplus is the source of today's huge global economic imbalance. China should be responsible for the unemployment in the United States, and even for the global financial crisis of 2008. So, China should quickly appreciate its currency.

However, in my view, the points set out above are wrong. Why?

Please look at this diagram. We can see, since 2001 when China joined WTO China’s current account surplus has increased drastically and reached its peak in 2007. Hereafter, the surplus has been going downward. Let’s look at the actual data. China's trade surplus gradually narrowed to $155 billion in 2011, from $183 billion in 2010, $196 billion in 2009 and $296 billion in 2008. The ratio of trade surplus to gross domestic product (GDP) dropped to about 2 percent in 2011 from 3.1 percent in 2010.

For the first quarter of 2012 as a whole, the value of total exports is $430.02 billion, while that of imports is $429.35 billion. The surplus is near zero. In recent years, China has actively increased imports in order to ameliorate trade balance. This policy has been quite effective. Over the next decade China will continue to seek trade balance. At this point, some Congressmen of the U.S. have really misunderstood China.

Let’s look at another fact. In 2011, German trade surplus reached $202 billion. So, the global largest trade surplus country is not China. For trade surplus to GDP ratio, Germany reached about 6%, and Russia was about 10%; while the trade deficit to GDP ratio in the United States was 4.8%, and the U.S. trade deficit to China accounted for only about one fifth of all U.S. trade deficit. So, China is also not the most imbalanced country. Why has the United States just chosen to blame China? I cannot understand this question.

Please look at this diagram. In 2005, China launched the reform of RMB exchange rate regime. Henceforth, China-U.S. bilateral exchange rate has appreciated by 30%. I remember, six years ago, some people argued that China’s RMB should appreciate 20%~40%. Even though in the past six years China’s currency has indeed appreciated more than 30%, and in today’s Hong Kong market RMB Non-Deliverable Forwards (NDFs) even has started its depreciation, these analysts are still claiming that RMB should appreciate 20%~40%. That is terrible incoherent.

Part Two: the Reasons for China-U.S. Trade Imbalance

First, on the demand side, China’s current account surplus has increased since 2002. Its export has been boosted by outside demands from irrational exuberance led by American property bubble such as asset securitization, and the soaring price of global commodity and energy. The primary cause is the U.S. Fed’s over-easing monetary policy after 9/11 attacks.

Second, on the supply side, there are two elements. The first is China’s entry into WTO in 2001. Hereafter, so much international capital has flowed into China, resulting in a fast surplus growth from processing trade. Another is that China had tailored its economic institutions to meet WTO rules and thus successfully improved its supply efficiency.

Third, from economic structure, China’s trade surplus exists only in its processing trade. In its general trade, China is actually experiencing a trade deficit. The reasons are China’s dual economic structure and cheap labor force. The economic structure in China and America is different. China’s trade surplus is a result of insufficient domestic demand. To dig further, that is achieved at the sacrifice of workers’ interests. The processing trade takes up 50% of China’s foreign trade. In this process, China only earns quite limited amount of “processing fee”. Most of the benefits go to transnational corporations.

For the United States, the trade deficit is a result of insufficient saving and overspending by the government and households. American national saving ratio has decreased to less than 1% from 13% during the 1990s. On one hand, the U.S. has spent a great deal of money on war and the development of advanced weapons. On the other hand, overspending becomes a popular practice. Particularly, Wall Street has spent money recklessly.

Therefore, the U.S. should increase savings and restrict governmental expenditure in order to reduce its fiscal and trade deficit and China should adjust income distribution in order to increase its domestic demand.

Lastly, we should notice that the ratio of China’s current account surplus to GDP is actually dropping. The trade surplus to GDP ratio in China has gradually increased since 2001, and reached its peak at about 8% in 2007. Thereafter, it has declined gradually. In 2011, it is 2% which is lower than the international standard of 4%. With the balance of payments (BOP) account moving closer to equilibrium, the basis for large-scale appreciation of the RMB exchange rate does not exist.

To sum up, in the process of globalization, China provides lower price commodities for global consumers. As a result, the citizens of import countries have enjoyed lower living costs and lower inflation rate. World economy has also enjoyed a sustainable development. In my opinion, China’s huge contribution should be recognized and commended by international community.

Part Three: Some Views on RMB Exchange Rate

In the past couple of years, Peterson Institute for International Economics has strongly believed that RMB is underestimated by at least 20% to 40%. Nobel Prize winner Paul R. Krugman has supported this argument and criticized that China has been manipulating RMB exchange rate for trade surplus, which imposed a great threat to the economic recovery for other countries.

Recently, the Peterson-based scholar Mr. Arvind Subramanian, the famous author of Eclipse: Living in the Shadow of China's Economic Dominance, released a series of papers, including “Spillover Effects of Exchange Rates: A Study of the Renminbi” and “Coming Soon: When the Renminbi Rules the World”. He argued that a 10 percent appreciation of the renminbi increases a developing country’s exports at the product-level on average by about 1.5 to 2 percent, and an appreciation of the renminbi could provide a substantial boost to developing country exports.

However, the real world has always been colorful and with different voices. In July 2010, Professor McKinnon published an article on Wall Street Journal, in which he titled “Wage Increase: The Win-win Answer on China Trade”. McKinnon argues that China should promote wage increase: first, Chinese wages would become closer to those in the developed countries, thus reducing protectionist pressures; second, the higher wage settlements would reverse the declining labors’ share in China’s GDP. In this light, household disposable income and domestic consumption demand can be increased and China’s economy will rely less on export. As a result, wage increase can be an effective solution to the trade imbalance between China and America.

Stephen Roach, the former Chief Economist of Morgan Stanley, pointed out that U.S. not only has a trade imbalance relation with China, but also with 90 other countries in the world. He also pointed out that forcing RMB appreciation does no good to the U.S., by which the biggest victim is the middle-class in the United States. Michael Spence, a Nobel laureate in economics, strongly supported Roach’s view.

In the beginning of 2010, Nobel Prize winner Joseph E. Stiglitz pointed out that the adjustment of RMB exchange rate against the U.S. dollar will not have a material impact on the U.S. trade, and its contribution to the job creation in the U.S. will be very limited; To the contrary, the short term exchange rate adjustment will even result in a speculative fluctuation in foreign exchange market.

Blanchard, the Chief Economist of IMF, has held that by making RMB appreciate, it provides little help to the economic resurgence of the United States. The job opportunity in the U.S. mostly depends on service sector, and it is terribly unrealistic to solve the unemployment problem in America by suppressing China’s manufacturing industry. At the end of 2009, Engel, the senior researcher of the Federal Reserve Bank of the United States, pointed out that the proper control of exchange rate and reduction of exchange rate fluctuation are helpful to the stability of global economy.

Therefore, for the RMB issue, there have been so many different opinions. In my view, some American Congressmen should listen to different voices.

Part Four: the Reform of RMB Exchange Rate Regime

Since 1994, the reform of RMB exchange rate regime has progressed in a self-initiated, gradual and controllable manner. The unification of dual exchange rates in the first day of 1994 marked the official beginning of the managed floating exchange rate regime. In 1994, the RMB exchange rate was 8.7 yuan to one dollar. In 1996, China introduced RMB convertibility under current account.

The Asian financial crisis in 1997 caused a slowdown in the improvement of managed floating exchange rate regime. After June 1997, some Asian currencies depreciated by a large margin. Yet, in order to prevent the further contagion of the crisis and preserve economic stability in Asia, China announced that the RMB would not be depreciated, its floating range would be narrowed, and its exchange rate would be kept stable around 8.28 yuan to one dollar. Thus, China had undergone the deflationary pressure.

The reform of exchange rate regime in 2005 was a continuation of the reform in 1994. Around 2003, China launched joint-stock reform in large state-owned banks. These large banks were listed in domestic and overseas markets. This reform reinforced the foundation for the reform of exchange rate regime. On July 21, 2005, China improved the managed floating exchange rate regime by basing it on market supply and demand with reference to a basket of currencies. 

Around end of July 2008, in order to cope with global financial crisis, China narrowed the floating range of RMB exchange rate and did not devalue the currency as many other countries did. This promoted global economic recovery. On June 19, 2010 the People’s Bank of China decided to push further the reform of exchange rate regime and enhance the flexibility of RMB exchange rate.

Especially, on April 13, 2012, the People’s Bank of China announced that since April 16, 2012, the floating band of RMB’s trading prices against the U.S. dollar in the inter-bank spot foreign exchange market has been enlarged from 0.5 percent to 1 percent. The spread between the RMB/USD selling and buying prices offered by the foreign exchange-designated banks to their customers has not exceeded 2 percent of the central parity, instead of 1 percent.

On April 14, 2012, Ms. Christine Lagarde, Managing Director of the International Monetary Fund (IMF), issued the statement in reaction to China’s policy. She said: “I would like to welcome this important step by the People’s Bank of China to increase the flexibility of their currency. This underlines China’s commitment to rebalance its economy toward domestic consumption and allow market forces to play a greater role in determining the level of the exchange rate.”

In conclusion, since 2005 the reform of RMB exchange rate regime has been progressing smoothly in a self-initiated, gradual and controllable process. It has promoted a balanced BOP account and supported economic growth. Also, it has demonstrated that China is dedicated to promote global economic balance and that China is a responsible member in the international community.

Part Five: Three Solutions for China-U.S. Trade Imbalance

In my view, the real exchange rate should include the relative prices of production factors such as wage, commodity, land, and resource. I provide three solutions as following:

The first solution: allowing one time substantial appreciation of nominal RMB exchange rate while keeping the wage at a low level. Therefore, the prices of China’s commodities measured by foreign currencies will rise, causing its exports and trade surplus to decrease drastically. But, this solution has huge negative impacts on China’s economy, leading to unemployment and the economic stagnation. Generally, because of the low level profits in labor-intensive enterprises, a moderate appreciation of exchange rate would make these enterprises financially troubled and decrease the resident income and consumption.

The second solution: allowing the real exchange rate to rise, in other words, let China’s production price such as wage, land, rent, and resource all grow. Meanwhile, make sure the nominal exchange rate remains unchanged. As a result, the product prices and exporting costs will rise. Thus China’s trade surplus will be reduced.

The third solution: implementing the policy of “gradual wage increase and gradual exchange rate appreciation”, which is also called “double gradual policy”. But, China’s wage increase and the exchange rate appreciation of RMB must be controlled in an acceptable scale in order to maintain a stable and sustainable economic development. Nominal exchange rate adjustment and relative price increase will lead to the increase of production costs among domestic enterprises. Thus, the Chinese trade surplus will gradually drop.

To sum up, the operational costs of the first solution are tremendous and it looks like a “big bang”. The second solution is seemly unfeasible in recent global context, while the third one is relatively rational and practical. Now, in the Hong Kong market, NDFs have started to fluctuate both ways. This tells us RMB is possibly near a balanced level. So, recently, China has stepped up the reform of RMB exchange rate regime by increasing the flexibility and two-way fluctuations.

Part Six: the United States’ Challenges and Proposals

Today, the United States is faced with many challenges such as unemployment, government debt, inflation, trade deficit, liquidity trap, and so on.

First，let’s look at the unemployment in the United States. This diagram shows that since global financial crisis of 2008, America has been experiencing a high unemployment and it remains at 8%-10%.

The second challenge is public debt. In this diagram we can see its total federal debt from 2000 to 2010 in the United States. The total federal debt has increased gradually. Nowadays, the U.S.’ federal debt to GDP ratio reaches near 100%.

The situation in this diagram is similar. Over the past thirty years the U.S. public debt ceiling has been rising. In every negotiation between Congress and White House, the Congress always gives in to White House.

Again, please look at this diagram. In the past thirty years the American federal government usually has deficit. In recent years, due to global financial crisis, the fiscal gap between federal tax revenue and expenditure has demonstrated an enlarging trend.

The next challenge is inflation. After global financial crisis of 2008 the U.S. central bank has twice implemented quantitative easing monetary policy. And thus we can see an accumulating inflationary pressure. The Fed normally keeps a 2%-3% inflation target, but since 2011 the United States has been facing a slight inflationary pressure.

The fourth challenge is trade deficit. This is a long-existing issue. Particularly, in the past decade this issue has even worsened. But, the United States continues to have difficulties in solving this issue.

Last challenge is the liquidity trap. It is a situation in which the short-term interest rates are near zero and the central bank’s interest rate policy fails. Over the past three years, the U.S. Central Bank has maintained the federal fund interest rate near zero. This policy has misguided the allocation of domestic resources. Moreover, it has increased inflationary pressure in emerging economies.

Basically, the biggest challenge in the United States is to create employment. But, it is impossible to solve this problem if the U.S. goes back to the traditional reindustrialization which includes labor and resource intensive industries, such as textiles and toys. Everyone understands this violates the objective rules.

In the beginning of this year, in his State of the Union address, President Obama argued that U.S. should not increase the market share of its products in China; Chinese products should be blocked from entering into U.S.; and the RMB exchange rate should appreciate fast, for the purpose of retaining some jobs for Americans.

In my view, this obviously doesn’t make any sense. In China, everybody knows the ancient story of Great Yu Controls the Waters of Yellow River. Yu's father, Gun, spent nine years building a series of dams to block flooding water, but failed. Great Yu created a lot of channels to guide water, thus succeeded. Maybe, President Obama should study China’s traditional philosophy.

By the way, over the next decade, China will increase its total import to $10 trillion. Facing such a huge opportunity, countries which hold more share of the market will develop faster and increase its employment. The United States has restricted the exports of hi-tech products to China. Evidently, this policy will give a lot of business opportunities to other countries such as Japan and Germany. The United States should highlight its competitive edges on the knowledge and technology intensive industries.

So, I want to give three proposals to the United States. First, release the restrictions on hi-tech products export to China, which can make higher profits and increase American employment in service sector. Second, expand Chinese FDI in rebuilding infrastructure, including airports, ports, expressways and high speed railway. Third, in new energy and environmental industries, the United States may combine its hi-tech superiority with China’s low labor costs in order to achieve low carbon and sustainable economic development.

In chief, the United States should promote bilateral trade cooperation, and strengthen the mutual trust, thus jointly share the achievements of China’s economic development.

Part Seven: China’s Challenges and Proposals

Today, China’s economy faces four challenges as follow. The first is whether it could succeed in driving a sustainable growth from enhancing domestic demand, especially consumption demand. The average level of income per capita has increased rapidly in China, but income inequality is becoming a very serious problem that may threaten social stability and the sustainability of economic development. In fact, China’s goal of spurring household consumption still remains elusive.

The second challenge is to achieve a more balanced growth and to tackle the negative impact of European debt crisis and American protectionism. So far, China’s economy is still reliant on exports and government-driven fixed asset investment. Official figures showed that since 2011 there was a sharp decline in foreign direct investment (FDI) and a sharp narrowing in China’s current account surplus. Unfortunately, this trend will continue.

The third challenge is to enhance the competitive ability of financial institutions and to deal with the local government debt. Specifically, a legacy of a $600 billion stimulus plan invested in major infrastructure projects would probably lead to non-performance loans for the commercial banks. China’s government has excessively protected the interests of banking sector, which has damaged the interests of households and enterprises to a certain extent. Undoubtedly, this policy has distorted China’s economic structure.

The fourth challenge is to enhance the innovative capacity of enterprises, especially private companies and SMEs. Recently, so many enterprises such as Foxxconn, have hiked worker wages. As a result, the increasing cost of enterprises aggravated China’s manufacturing. The cumulative combination of inflation, RMB appreciation, and wages increase has negatively impacted on the competitive edge of China’s economy.

In next step, China will further deepen three reforms. To begin with, deepen the fiscal and taxation reforms and income distribution system, which includes increase the dividends of state-owned enterprise and the resource tax on oil and coal mining; cut the SME taxation; raise the proportion of individual income in national income; raise the proportion of middle-income groups and the incomes of low-income groups.

Second, deepen the reform of financial systems, which includes develop small financial institutions and improve the mechanisms that serve small and micro businesses as well as agriculture; develop capital market such as improve both initial public offering and delisting; develop the bond market in order to make interest rates more market based; make the RMB convertible under capital accounts, expand the use of RMB in cross-border trade and investment, and promote the reform of the RMB exchange rate regime.

Third, set up the reforms of social safety-net to finally provide universal social welfare coverage that could include the rural population and migrant workers in China's cities. More public funds will be available to rural education and rural health care. More public services will be provided to newly urbanizing migrants in order to increase household consumption and reduce the current-account surplus.

Thank you for attention.