Why China’s Currency Manipulation Doesn’t Matter

With just a few words in his Senate confirmation hearing, U.S. Treasury Secretary Timothy Geithner resurrected the long-held American accusation that China’s penchant for money management is hurting the U.S. economy. President Obama — backed by the conclusions of a broad range of economists — believes that China is manipulating its currency, Geithner wrote in his prepared remarks.

As the argument goes, an undervalued Chinese currency makes the country’s exports artificially cheap, giving Chinese goods an unfair competitive edge. Reduced demand for American goods hurts U.S. manufacturers and limits the size of the U.S. job market. China is taking jobs from the American heartland.

Blaming China for flailing U.S. manufacturing may be good domestic politics, but Geithner should hold his tongue. First, there is little evidence that a currency appreciation would have an effect on the U.S. economy — let alone a positive one. Regardless, China will be compelled to appreciate its currency out of economic necessity in coming years. And because the United States has very few channels through which to push for appreciation, the yuan is better left alone.

Geithner’s is certainly not the last Western complaint we will hear of China’s currency, particularly now with an economic crisis in full swing. Yet many experts contend that there is actually no connection between the yuan and the health of U.S. manufacturing. Former Federal Reserve Chairman Alan Greenspan testified in 2005: I am aware of no credible evidence that … a marked increase in the exchange value of the Chinese [yuan] relative to the dollar would significantly increase manufacturing activity and jobs in the United States.

The transition away from manufacturing is a long-term international trend that goes far beyond competition from Chinese exports. Jobs have been cut because technological improvements have simply made each worker more productive. A study by Alliance Capital Management (now AllianceBerstein) found that manufacturing employment in the world’s 20 largest economies declined by 22 million workers from 1995 to 2002, while manufacturing output in those countries increased 30 percent. During that period, China lost 15 million manufacturing jobs, while the United States lost just 2 million.

If anything, Chinese currency intervention actually has several positive consequences for the U.S. economy. China has a large investment in U.S. debt, which helps keep U.S. interest rates low, allowing firms to make investments that would be unattractive at a higher cost of borrowing. Such investments increase the amount of capital available and thereby boost employment and the size of the economy. An undervalued yuan also reduces U.S. dollar inflation. And by keeping imports cheap, it increases the purchasing power of the average U.S. consumer.

Nor is the oft-cited U.S. trade deficit with China, which reached $246 billion in 2008, truly a result of currency manipulation or the resulting lower wages paid to Chinese industrial workers. In fact, the imbalance is the result of a gaping difference between U.S. savings and investment. In 2008, the U.S. savings rate was a mere 3 percent, whereas China’s savings rate was a whopping 50 percent. In 2006, the ratio of domestic savings to national investment in the United States was 68 percent; meaning 32 cents of every dollar invested needed to come from foreigners. The same ratio was 118 percent in China, meaning that China sent abroad 18 cents out of every dollar the country invested. Unless these savings and investment patterns change, a rising yuan will have no effect on the U.S. trade deficit with China.

In any case, market forces will compel China to appreciate its currency in coming years for domestic reasons. Today, the People’s Bank of China (PBOC) devalues its currency by purchasing U.S. Treasury securities. In doing so, it must first convert yuan to dollars, thereby releasing more Chinese currency into circulation, devaluing it and increasing inflation in the process. The PBOC sterilizes the purchase by simultaneously selling yuan-denominated PBOC bonds, which remove yuan from circulation, negating the inflationary effect of the intervention.

But sterilization is becoming problematic for the PBOC. First, the process has not been fully effective. Money-supply growth accelerated from 14.6 percent in 2004 to 17.8 percent in 2008, pushing China to a peak inflation of 8.7 percent in 2008, far above the government’s target of 4.8 percent. Likewise, due to the immense scope of China’s past intervention, the amount of PBOC bonds outstanding is now equal to more than half of the total amount of yuan in circulation. Demand for PBOC bonds is low, which means interest rates are rising and relatively high, about 5.31 percent currently, compared with U.S. short-term interest rates near 0 percent. The cost to the PBOC of receiving little or no interest on the U.S. bonds it owns and paying 5 percent interest on its own bonds is more than $4 billion a month, according to estimates by Goldman Sachs. China’s foreign currency holdings, which total more than $2 trillion, are growing faster than the Chinese economy. In coming years, these realities will make intervention and sterilization untenable.

Pegging its currency to the U.S. dollar, the PBOC has also forfeited the ability to use monetary policy to manage its economy. As China’s economy grows larger and less correlated with that of the United States’, this will become increasingly problematic. There is also a large opportunity cost, as $2 trillion of foreign reserves could be invested in any number of beneficial internal projects.

There is neither need — nor a way — to browbeat China into appreciating the yuan sooner. Diplomatic pressure has had limited effect thus far. The United States also has the option of appealing to the World Trade Organization to impose trade sanctions, or it could impose sanctions unilaterally. Both are unlikely. The G-7 is currently split on whether currency intervention should be allowed, as other members have threatened intervention themselves in recent weeks. As for unilateral sanctions, they would be more detrimental to the U.S. economy than the policies they would seek to punish, even if China did not retaliate, which it likely would.

If the United States is looking to pressure China, perhaps it would do better to focus on issues where real results are possible. It should encourage China to honor the commitments it made in joining the WTO, such as reducing pollution and improving its human rights record. And finally, if it truly seeks to make its workers more competitive with those in China and elsewhere over long term, the United States should take a hard look in the mirror, and focus on raising worker productivity and reforming its educational system rather than on illusory exchange rate gains and protectionist policies.