Don’t Worry about the Yuan

Wednesday, April 16, 2008
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Conventional wisdom holds that bipartisanship leads to improved public policy. A striking illustration to the contrary is the Currency Exchange Rate Oversight Reform Act of 2007, a bill supported by Democratic chairs and ranking Republican members of the relevant committees in the Senate and House that would punish China for its “misaligned” currency, the yuan. Its mistaken premise is that this misalignment threatens our prosperity by causing America’s large current-account deficits with China.

China’s current-account surplus—the sum of its trade surplus and net receipts from foreign assets and foreign remittances—came to about $300 billion in 2007, nearly 10 percent of its GDP. Two-thirds of this amount, $200 billion, represents a bilateral surplus with the United States. The U.S. global current-account deficit was about $800 billion, nearly 6 percent of U.S. GDP. Thus, China’s bilateral current-account surplus with the United States equaled one-quarter of the global U.S. deficit.

In 2005, the yuan was worth 12 U.S. cents. It is currently worth 13.5 cents. Many believe that were the yuan’s exchange value to increase further, perhaps to 17 or 18 cents, the bilateral imbalance between the two countries would be substantially reduced, if not eliminated. China’s exports to the United States would thereby become more expensive in dollars and would therefore decrease, while China’s imports from the United States would become less expensive in yuan and therefore would increase. If China failed to make such a currency adjustment, the pending legislation in Congress would impose a tax on imports from China to offset the putative currency undervaluation.

This reasoning, though plausible, is wrong. A country’s global current account deficit depends on the excess of its gross domestic investment over gross domestic savings. Gross savings in the United States are about 10–12 percent of GDP and consist largely of corporate depreciation allowances and retained corporate earnings. By contrast, gross domestic investment is 16–17 percent of GDP. The difference between the two makes up the U.S. current-account deficit.

China’s current-account surplus is the mirror image of the U.S. imbalance. Gross investment in China is above 30 percent of its GDP, but its savings are even higher, above 40 percent.

Although the appreciation of the yuan might initially raise U.S. exports to China and lower China’s exports to the United States, these effects would be small and transitory as long as the imbalances between savings and investment persist in the two economies. Japan and Germany—two countries with perennial current-account surpluses—illustrate the point.

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While Japan’s yen has appreciated against the dollar in the past several years, its current-account surplus is largely unchanged because Japan’s domestic savings have continued to exceed its domestic investment. The euro has appreciated 30 percent relative to the dollar, yet Germany maintains a large global current-account surplus. That’s because the German economy maintains an excess of savings over investment. (The economies of most other euro zone countries show a savings shortfall and continue to incur current-account deficits.)

In both Germany and Japan, the excess of domestic savings over domestic investment persists, and hence their current-account surpluses persist, notwithstanding their currencies’ appreciation.

To reduce the bilateral imbalances between China and the United States requires more carefully crafted policies than revaluation of the yuan. If correcting China’s imbalance were sought by increasing gross domestic investment to match domestic savings, rampant inflation above the present 6.6 percent annual rate (already twice that of a year ago) could result—because soaring demand for materials, plant, and equipment would in the near term sharply boost their prices. China is already experiencing this sequence. If correcting the U.S. imbalance were sought by lowering investment to a level closer to the U.S. current savings rate, a serious recession in China would likely result.

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Effective remedial policies for China lie in raising domestic consumption (reducing domestic savings) by 4–5 percent of GDP through such measures as wider dissemination of credit and debit cards and other consumer credit instruments. Remedial policies for the United States lie in raising current savings by 2–3 percent of U.S. GDP through curbing government spending, instituting personal retirement accounts to supplement the defined benefits of Social Security, establishing a graduated consumption tax, or arranging a combination of these measures.

To reduce the imbalances between China and the United States requires more carefully crafted policies than a revaluation of the currency.

In the United States, such measures have been advocated by some members of both parties. But more important than their potential bipartisan support, they would warrant nonpartisan support because they, unlike currency realignment, would actually address the underlying sources of the U.S. and Chinese imbalances.