Hoover Daily Report

Chinese 'Currency Manipulation' Is Not the Problem

via Wall Street Journal
Monday, January 7, 2013

When things are not going well, it is common to seek scapegoats. In this vein, populists of various stripes allege that China manipulates the value of its currency to favor its exports and undercut American workers, particularly in manufacturing.

The reality is that the value of China's yuan in terms of dollars is not the major reason why China exports over three times as much to us as we do to them. Its exchange rate is a minor source of weak U.S. job growth.

From 1995 to 2005, China pegged its currency, holding it steady at slightly over eight yuan to the dollar. Then, in late 2005, China allowed its currency to appreciate relative to the dollar until July 2008. The rate held steady again for the two years following that date at 6.8 yuan to the dollar. In 2010, gradual appreciation occurred again. The current exchange rate now stands at about 6.2 yuan per dollar, which means that a yuan is worth about 16 cents.

If currency movements were the key factor in determining trade patterns, one would expect that exports to the U.S. from China would bear a strong relation to currency movements. They have not.

The dollar-yuan exchange rate did not change from 1995 to 2005, and during this period China's exports to the U.S. increased sixfold, or at a rate of about 19.6% per year. Then, from 2005 to 2008, the value of the yuan relative to the U.S. dollar appreciated by about 21%. China's currency was "stronger" and its exports in dollars were more expensive—so Chinese exports to the U.S. should have fallen. Instead, China's exports to the U.S. continued to grow at about the same pace, averaging 18.2% per year.

The only period during which exports from China to the U.S. fell to any significant extent was during the recent recession, dropping by about one-third from late 2008 to early 2010. The dollar-yuan exchange rate was unchanged throughout this entire period. The obvious explanation for the decline in Chinese exports to the U.S. was the decline in demand for consumption goods in general.

A comparison of Chinese exports to Europe with those to the United States provides additional evidence on the role that exchange rates play in trade. At the end of 2000, it cost 0.13 euros to buy one yuan. At the end of 2004, it cost only 0.09 euros to buy one yuan. Chinese exports to Europe should have risen relative to those to the U.S. because the exchange rate between the U.S. and China remained constant at 12 cents per yuan throughout this period.

Indeed, consistent with the fact that the yuan cheapened for Europeans but not for Americans, growth in Chinese exports to Europe averaged 35% per year and 32% per year for exports from China to the U.S. during this period. But the more important message here is that the growth of Chinese exports to the two regions was almost the same—even though the euro bought 44% more yuan at the end of the period than it did at the beginning, while the dollar's relationship to the yuan remained unchanged.

The chart nearby shows Chinese exports to the U.S. (green line) and Chinese exports to Europe (red line). They move almost perfectly together over all periods, including those when the euro strengthened relative to the dollar and to the yuan. This is more evidence that export growth is determined primarily by factors other than exchange rates.

There is another lesson here. The demand that China align its currency more closely to market forces is, in its purest form, a demand that Beijing allow the yuan to float. What would occur if China did this? Well, consider that China has throughout recent history tied its currency to the U.S. dollar, but because the dollar floats relative to other currencies, the yuan as a consequence also floats relative to other currencies, and in particular, relative to the euro.

So if floating exchange-rates affected trade differently from fixed rates, then trade patterns should also have been different. Yet as the chart shows, exports to the Europe and to the U.S. move together very closely. Apparently, having a currency that floats relative to another is not the most important factor in determining exports.

What does determine trade activity? There is an abundant literature that analyzes trade flows between one country and another. Among the most successful analyses are those that use "gravity" models, which say that trade between countries is determined primarily by the size of the trading countries and by the distance between them. As countries grow and acquire more "mass," so to speak, they attract more exports from others. At the same time, other countries tend to import more from larger countries.

Thus the growth of trade between China and the rest of the world not only contributed to China's growing size, but the reverse is also true. Rapid economic growth made China a larger target for and source of traded goods.

While exchange rates are not the major factor in trade, studies (including a 2011 trade policy paper by the Organization for Economic Co-operation and Development) show that they do have some effect on trade flows, particularly in the short-run.

Thus exports from China to Europe did increase a bit relative to those to the U.S. when the euro strengthened relative to the yuan and dollar. This is true from 2000 to 2004. It is also true since mid-2007, when a falling dollar made the purchasing power of the euro relatively greater and Chinese exports to Europe became greater than Chinese exports to the U.S.—although the bulk of Chinese exports to Europe and the U.S. still move in tandem. Exchange rates are not the main determinant of trade flows.

Is China a currency manipulator? Indeed it is—as are all countries that maintain a fixed or a close-to-fixed ratio of their currency relative to the dollar, euro or gold.

Denmark could be similarly labeled a currency manipulator because it adjusts its monetary policy to maintain a fixed ratio of Danish kroner to the euro. Japan has moved toward a looser monetary policy to cheapen the yen, which has fallen 13% relative to the dollar since September. China adjusts its monetary policy and credit controls to maintain the value of the yuan relative to the dollar (or in the past few years, to an undisclosed basket of currencies).

But China's choice of exchange rate policy is not the source of China's export growth. Disappointing job and wage growth in the U.S. has much more to do with our economic policy than with the value of China's currency.

Mr. Lazear, chairman of the President's Council of Economic Advisers from 2006-2009, is a professor at Stanford University's Graduate School of Business and a fellow at the Hoover Institution.