The Renminbi: The Political Economy of a Currency
Why it's a mistake for the United States to fear the yuan.
The Chinese currency, or renminbi (RMB), has been a contentious issue for the past several years. Most recently, members of the U.S. Congress have suggested tying China currency legislation to the upcoming votes on the free trade agreements with South Korea, Colombia, and Panama. While not going that far, Senate Majority Leader Harry Reid and Sen. Charles Schumer have promised a vote on the issue sometime this year.
The root of the conflict for the United States — and other countries — is complaints that China keeps the value of the RMB artificially low, boosting its exports and trade surplus at the expense of trading partners. Recent government data show that the bilateral trade deficit between the U.S. and China grew nearly 12 percent in the first half of 2011 — fueling U.S. efforts to boost job creation domestically by authorizing import tariffs and other restrictions on countries that manipulate their currencies.
Although the U.S. Treasury has repeatedly stopped short of labeling China a "currency manipulator" in its twice-yearly reports to Congress, it has consistently pressured China to allow the RMB to appreciate at a faster pace and to let the currency fluctuate more freely in line with market forces. The International Monetary Fund (IMF), the World Bank, and many economists have also argued for faster appreciation and a more flexible exchange-rate policy as part of a broader program of "rebalancing" the Chinese economy away from its traditional reliance on exports and investment and toward a more consumer-driven growth model. Partly in response to these pressures, but more because of domestic considerations, China has allowed the RMB to rise by about 25 percent against the U.S. dollar since mid-2005. Yet the pace of appreciation remains agonizingly slow for the United States and other countries in Europe and Latin America whose manufacturing sectors face increasing competition from low-priced Chinese goods.
The international conversation over the RMB remains perennially vexed because China and its trade partners have fundamentally divergent ideas on the function of exchange rates. The United States and other major developed economies, as well as the IMF, view an exchange rate simply as a price. Consistent intervention by China to keep its exchange rate substantially below the level the market would set is, in this view, a distortion that prevents international markets from functioning as well as they could. This price distortion also affects China’s own economy by encouraging large-scale investment in export manufacturing, and discouraging investment in the domestic consumer market. Thus it is in the interest of both China itself and the international economy as a whole for China to allow its exchange rate to rise more rapidly.
Chinese officials take a very different view. They see the exchange rate — and prices and market mechanisms in general — as tools in a broader development strategy. The goal of this development strategy is not to create a market economy, but to make China a rich and powerful modern country. Market mechanisms are simply means, not ends in themselves. Chinese leaders observe that all countries that have raised themselves from poverty to wealth in the industrial era, without exception, have done so through export-led growth. Thus they manage the exchange rate to broadly favor exports, just as they manage other markets and prices in the domestic economy to meet development objectives such as the creation of basic industries and infrastructure. These policies do not differ materially from those pursued by Japan, South Korea, and Taiwan since World War II, or by Britain, the United States, and Germany in the 19th century. Because the Chinese leaders perceive that an export-led strategy is the only proven route to rich-country status, they view with profound suspicion arguments that rapid currency appreciation and markedly slower export growth are "in China’s interest." And because China — unlike Japan in the 1970s and 1980s — is an independent geopolitical power, it is fully able to resist international pressure to change its exchange-rate policy.
A second issue raised by China’s currency and trade policies is the persistent trade surplus since 2004 that has contributed to about three-quarters of the nearly $3 trillion increase in China’s foreign exchange reserves over the past eight years. Close to two-thirds of these reserves are invested in U.S. Treasury debt. Some fear that China has become the United States’ banker and could cause a collapse in the U.S. dollar and the U.S. economy by dumping its dollar holdings. Others suggest that China’s recent moves to increase the international use of the RMB through an offshore market in Hong Kong signal China’s intent to build up the RMB as an international reserve currency to rival or eventually supplant the dollar. All these concerns are based on serious misunderstandings of both international financial markets and China’s domestic political economy. China is not in any practical sense "America’s banker"; it is more a depositor than a lender, and its economic leverage over the United States is very modest.
And while China’s leading position in global trade makes it quite sensible to increase the use of the RMB for invoicing and settling trade, it is a huge leap from making the RMB more internationally traded to making it an attractive reserve currency. China does not now meet the basic conditions required for the issuer of a major reserve currency, and may never meet them. Most importantly, the RMB is unlikely to become more than a second-tier reserve currency so long as Chinese leaders cling to their deep reluctance to allow foreigners a significant role in China’s domestic financial markets.
China’s Currency Policies
China’s exchange-rate policy must be understood within the context of two political-economic factors: first, China’s overall development strategy, which aims to build up the country’s economic and political power with market mechanisms as tools to that end rather than ends in themselves; and second, China’s geopolitical position.
The Chinese development strategy, which emerged gradually after Deng Xiaoping began the process of "reform and opening" in 1978, is based on a careful study of how other industrial countries got rich — and in particular, the catch-up growth strategies of its East Asian neighbors Japan, South Korea, and Taiwan after World War II. A key lesson of that study is that every rich country, in the early stages of its development, used export-friendly policies to promote domestic industry and to accelerate technology acquisition. In earlier eras, when the use of the gold standard made it impossible to maintain permanently undervalued exchange rates, countries used administrative coercion and high tariffs to achieve the same effect of favoring domestic manufacturers over foreign ones. Britain’s policies of using colonies as captive markets for its manufactured exports, and prohibiting those colonies from exporting manufactures back to Britain, were important components of that country’s rise to become the world’s leading industrial power in the late 18th and 19th centuries. Resentment of those policies was one cause of the American Revolution; once independent, the United States spurred its economic development through the "American system," which featured high tariff walls (often 40 percent or more) through the 19th and into the early 20th century. Germany used similar protective policies to foster its industries in the late 19th century. Countries did not become advocates for free trade until their firms were secure in global technological leadership. The need for protection waned for Britain in the mid-19th century; for the United States, the mid-20th.
After World War II, undervalued exchange rates became an important tool of export promotion, partly because new global trading rules under the General Agreement on Tariffs and Trade (GATT, which morphed into the World Trade Organization in 1995) made it more difficult to maintain extremely high levels of tariff protection. The testimony of postwar economic history is quite clear. Countries that maintained undervalued exchange rates and pursued export markets enjoyed sustained high-speed economic growth and became rich. These countries include Germany, Japan, South Korea, and Taiwan. Countries that used other mechanisms to block imports and encouraged their industrial firms to cater exclusively to domestic demand — so-called "import substitution industrialization," or ISI, which usually involved an overvalued exchange rate — in some cases grew quite rapidly for 10 years or more. But this growth could not be sustained because the ISI strategy includes no mechanism for keeping pace with advances in global technology. Most ISI countries, including much of Latin America and the whole of the communist bloc, experienced severe financial crisis and fell into long periods of stagnation.
As it tried to accelerate growth by moving from a planned to a more market-driven economy in the 1980s, China gradually depreciated the RMB by a cumulative 80 percent, from 1.8 to the dollar in 1978 to 8.7 in 1995. Since then, however, the RMB has only appreciated against the dollar, moving up to a rate of 8.3 by 1997 and holding steady at that rate until mid-2005 after which gradual appreciation resumed. Since 2006 the RMB has appreciated at an average annual rate of about 5 percent against the dollar to its current rate of about 6.4, and it is likely that this average rate of appreciation will be sustained for the next several years. This history demonstrates that supporting export growth, while important, is not the sole determinant of China’s exchange-rate policy. During the 1997-1998 Asian financial crisis, the consensus of most economists held that the RMB was overvalued; despite this, Beijing kept the value of the RMB steady, on the grounds that devaluation would further destabilize the battered Asian regional economy. As a consequence, China endured a few years of relatively anemic growth in exports and GDP, and persistent deflation. The leadership decided that this was a price worth paying for regional economic stability.
Conversely, the appreciation since 2005 reflects Beijing’s understanding that clinging to a seriously undervalued exchange rate for too long risks sparking inflation. This occurred from 2005 to 2007 in many oil-rich Persian Gulf countries, which held fast to unrealistically low pegged exchange rates and suffered annual inflation rates of 20 percent to 40 percent. For Chinese leaders, an inflation rate above 5 percent is considered dangerously high, and the most rapid currency appreciation in the last few years has occurred when inflationary pressure was relatively strong. A second reason for switching to a policy of gradual appreciation was the view that an ultra-cheap exchange rate disproportionately benefited manufacturers of ultra-cheap goods, whose technology content and profit margins were low. While these industries provided employment for millions, they did not contribute much to the country’s technological upgrading. A gradual currency appreciation, economic policymakers believed, would eventually force Chinese manufacturers to move up the value chain and start producing more sophisticated and profitable goods. This strategy appears to be bearing fruit: China is rapidly gaining global market share in more advanced goods such as power generation equipment and telecoms network switches. Meanwhile, it has begun to lose market share in low-end goods like clothing and toys, to countries like Vietnam, Cambodia, Indonesia, and Bangladesh.
In short, China’s exchange-rate policy is mainly driven by the aim of enhancing the country’s export competitiveness. But other factors play a role, namely a desire to maintain domestic and regional macroeconomic stability, keep inflationary pressures at bay, and force a gradual upgrading of the industrial structure. From Chinese policymakers’ point of view, all these objectives suggest that the exchange rate should be carefully managed, rather than left to unpredictable market forces. While economists may argue that long-run economic stability is better served by a more flexible exchange rate, Chinese officials can point to the excellent track record their policies have produced: consistent GDP growth of around 10 percent a year since the late 1990s, inflation consistently at or below 5 percent, export growth of more than 20 percent a year, and a steady increase in the sophistication of Chinese exports. Until some kind of crisis convinces them that their economic policies require major adjustment, China’s economic planners are likely to stick with their current formula.
International pressure to accelerate the pace of RMB appreciation is unlikely to have much impact because other countries have very little leverage that they can bring to bear. In the 1970s, the United States was able to pressure Germany and Japan to appreciate their currencies because those countries were militarily dependent on America. (Moreover, the United States was able unilaterally to engineer a devaluation of the dollar by going off the gold standard in 1971.) Japan’s position of dependency forced it to accede to the 1985 Plaza Accord, which resulted in a doubling of the value of the yen over the next two years. China, being geopolitically independent, has no incentive to bow to pressure on the exchange rate from the United States, let alone Europe or other countries such as Brazil. The only plausible threat is that failure to appreciate the RMB could lead to a protectionist backlash that would shut the world’s doors to Chinese exports. Yet this threat has so far proved empty: Even after three years of the worst global recession since the Great Depression, trade protectionism has failed to emerge in the United States or Europe.
Other considerations further strengthen the Chinese determination not to give in to foreign pressure on the exchange rate. One is the Japanese experience after the Plaza Accord. The generally accepted view in China is that the yen’s dramatic appreciation in the late 1980s was a crucial contributor to Japan’s dramatic asset-price bubble whose collapse after 1990 set the former world-beating economy on a two-decade course of economic stagnation. Chinese officials are adamant that they will not repeat the Japanese mistake. This resolve was strengthened by the 2008 global financial crisis, which in China thoroughly discredited the idea — already held in deep suspicion by Chinese leaders — that lightly regulated financial markets and free movements of capital and exchange rates are the best way to run a modern economy. China’s rapid recovery and strong growth after the crisis are deemed to vindicate the country’s strategy of managing the exchange rate, controlling capital flows, and keeping market forces on a tight leash.
The Internationalization of the RMB
Despite this generally self-confident view of the merit of its exchange-rate and other economic policies, Chinese leaders are troubled by one headache caused by the export-led growth strategy: the accumulation of a vast stockpile of foreign exchange reserves, most of which are parked in very low-yielding dollar assets, principally U.S. Treasury bonds and bills. For a while, the accumulation of foreign reserves was viewed as a good thing. But after the 2008 financial crisis, the perils of holding enormous amounts of dollars became evident: A serious deterioration of the U.S. economy leading to a sharp decline in the value of the dollar could severely reduce the worth of those holdings. Moreover, the pervasive use of the dollar to finance global trade proved to have hidden risks: When U.S. credit markets seized up in late 2008, trade finance evaporated and exporting countries such as China were particularly hard hit. The view that excessive reliance on the dollar posed economic risks led Chinese policymakers to undertake big efforts to internationalize the RMB, beginning in 2009, through the creation of an offshore RMB market in Hong Kong.
Before considering the significance of RMB internationalization, it’s worth addressing some misconceptions about China’s large-scale reserve holdings and investments in U.S. Treasury bonds. Because China’s central bank is the biggest single foreign holder of U.S. government debt, it is often said that China is "America’s banker" and that, if it wanted to, it could undermine the U.S. economy by selling all of its dollar holdings, thereby causing a collapse of the U.S. dollar and perhaps the U.S. economy. These fears are misguided. First, it is by no means in China’s interest to cause chaos in the global economy by prompting a run on the dollar. As a major exporting country, China would be among the biggest victims of such chaos. Second, if China sells U.S. Treasury bonds, it must find some other safe foreign asset to buy, to replace the dollar assets it is selling. The reality is that no other such assets exist on the scale necessary for China to engineer a significant shift out of the dollar. China accumulates foreign reserves at an annual rate of about $400 billion a year; there is simply no combination of markets in the world capable of absorbing such large amounts as the U.S. Treasury market. It is true that China is trying to diversify its reserve holdings into other currencies, but at the end of 2010 it still held 65 percent of its reserves in dollars, well above the average for other countries (60 percent). From 2008 to 2010, when newspapers were filled with stories about China "dumping dollars," China actually doubled its holdings of U.S. Treasury securities, to $1.3 trillion.
The other crucial point is that China is not in any meaningful sense "America’s banker," and its economic leverage is modest. China owns just 8 percent of the outstanding stock of U.S. Treasury debt; 69 percent of Treasury debt is owned by American individuals and institutions. Measured by Treasury debt holdings, America is America’s banker — not China. And China’s holdings of all U.S. financial assets — federal, municipal, and corporate debt; equities; and so on — is a trivial 1 percent.
Chinese commercial banks lend almost nothing to American firms or consumers. The gross financing of American companies and consumers comes principally from U.S. banks and secondarily from European ones. It is more apt to think of China as a depositor at the "Bank of the United States": its Treasury bond holdings are supersafe, liquid holdings that can be easily redeemed at short notice, just like bank deposits. Far from holding the United States hostage, China is a hostage of the United States because it has little ability to move those deposits elsewhere — no other bank in the world is big enough.
It is precisely this dependency that has prompted Beijing to start promoting the RMB as an international currency. By getting more companies to invoice and settle their imports and exports in RMB, China can gradually reduce its need to put its export earnings on deposit at the "Bank of the United States." But again, headlines suggesting that internationalization of the RMB heralds the imminent demise of the current dollar-based international monetary system are premature.
The simplest reason is that the RMB’s starting point is so low that many years will be required before it becomes one of the world’s major traded currencies. In 2010, according to the Bank for International Settlements, the RMB figured in less than 1 percent of the world’s foreign exchange transactions, less than the Polish zloty; the dollar figured in 85 percent and the euro in 40 percent. There is no question that use of the RMB will increase rapidly. Since Beijing started promoting the use of RMB in trade settlement (via Hong Kong) in 2009, RMB-denominated trade transactions have soared: Around 10 percent of China’s imports are now invoiced in RMB. The figure for exports is lower, which makes sense. Outside China, people sending imports to China are happy to be paid in RMB because they can reasonably expect that the currency will increase in value over time. But Chinese exporters wanting to get paid in RMB will have a difficult time finding buyers with enough RMB to pay for their shipments. Over time, however, foreign companies buying and selling goods from China will become increasingly accustomed to both receiving and making payments in RMB — just as they grew accustomed to receiving and making payments in Japanese yen in the 1970s and 1980s.
Because China is already the world’s leading exporter and is likely to surpass the United States as the world’s leading importer within three or four years, it’s quite natural that the RMB should become a significant currency for settling trade transactions. Yet the leap from that role to a major reserve currency is a very large one, and the prospect of the RMB becoming a reserve currency on the order of the euro — let alone replacing the dollar as the world’s dominant reserve currency — is remote. The reason is simple: To be a reserve currency, you need to have safe, liquid, low-risk assets for foreign investors to buy; these assets must trade on markets that are transparent, open to foreign investors, and free from manipulation. Central banks holding dollars and euros can easily buy lots of U.S. Treasury securities and euro-denominated sovereign bonds; foreign investors holding RMB basically have no choice but to put their cash into bank deposits. The domestic Chinese bond market is off-limits to foreigners, and the newly created RMB bond market in Hong Kong (the so-called "Dim Sum" bond market) is tiny and consists mainly of junk-bond issuances by mainland property developers.
Again, we can reasonably expect rapid growth in the Hong Kong RMB bond market. But the growth of that market, and granting foreigners access to the domestic Chinese government bond market, remain severely constrained by political considerations. Just as Chinese officials do not trust markets to set the exchange rate for their currency, they do not trust markets to set the interest rate at which the government can borrow. Over the last decade Beijing has retired virtually all its foreign borrowing; more than 95 percent of Chinese government debt is issued on the domestic market, where the principal buyers are state-owned banks that are essentially forced to accept whatever interest rate the government dictates. There is absolutely no reason to believe that the Chinese government will at any point in the near future surrender the privilege of setting the interest rate on its own borrowings to foreign bond traders over whom it has no control. As a result, it is likely to be many years before there is a large enough pool of internationally available safe RMB assets to make the RMB a substantial international reserve currency.
In this connection the example of Japan provides an instructive example. In the 1970s and 1980s Japan occupied a position in the global economy similar to China’s today. It had surpassed Germany to become the world’s second-biggest economy, and it was accumulating trade surpluses and foreign exchange reserves at a dizzying rate. It seemed a foregone conclusion that Japan would become a central global financial power and the yen a dominant currency. Yet this never occurred. The yen internationalized: Nearly half of Japanese exports were denominated in yen, Japanese firms began to issue yen-denominated "samurai bonds" on international markets, and the yen became an actively traded currency. Yet at its peak the yen never accounted for more than 9 percent of global reserve currency holdings, and the figure today is around 3 percent. The reason is that the Japanese government was never willing to allow foreigners meaningful access to Japanese financial markets and in particular the Japanese government bond market. Even today, about 95 percent of Japanese government bonds are held by domestic investors, compared with 69 percent for U.S. Treasury securities. China is not Japan, of course, and its trajectory could well be different. But the bias against allowing foreigners meaningful participation in domestic financial markets is at least as strong in China as in Japan, and so long as this remains the case it is unlikely that the RMB will become anything more than a regional reserve currency.
Implications for U.S. Policy
The above analysis suggests two broad conclusions of relevance to U.S. policymakers. First, China’s exchange-rate policy is deeply linked to long-term development goals, and there is very little that the United States, or any other outside actor, can do to influence this policy. Second, the same suspicion of market forces that leads Beijing to pursue an export-led growth policy that generates large foreign reserve holdings also means that Beijing is unlikely to be willing to permit the financial market opening required to make the RMB a serious rival to the dollar as an international reserve currency. A related observation is that an average annual appreciation of the RMB against the dollar of about 5 percent now seems to be firmly embedded in Chinese policy. An appreciation of this magnitude enables China to maintain export competitiveness while achieving two other objectives: keeping domestic consumer-price inflation under control and gradually forcing an upgrade of China’s industrial structure.
Generally speaking, these trends are quite benign from a U.S. perspective. In substantive terms, there is little to be gained from high-profile pressure on China to accelerate the pace of RMB appreciation, because the United States possesses no leverage that can be plausibly brought to bear. Although the persistent undervaluation of the RMB will present increasing difficulties for American manufacturers of high-end equipment, as Chinese manufacturers gradually become more competitive in these sectors, the steady appreciation of the currency will increase the purchasing power of the average Chinese consumer and the total size of the Chinese consumer market. U.S. policy should therefore de-emphasize the exchange rate, where the potential for success is limited, and instead focus on keeping the pressure on China to maintain and expand market access for American firms in the domestic Chinese market — which in principle is provided for under the terms of China’s accession to the World Trade Organization.