China Syndrome

May 9, 2005 • Commentary
This article appeared in The Wall Street Journal on May 9, 2005.

In the 1980s and early ‘90s, Japan bashing was the favorite pastime in Washington. Japan’s sin: its large “contribution” to a growing U.S. trade deficit. To solve this “problem,” the U.S. demanded that Japan either strengthen the yen or face trade sanctions. Japan reluctantly complied. In Tokyo, “voluntary” export quotas and an ever‐​appreciating yen policy became orders of the day. But that one‐​two policy punch missed its target. Both the U.S. trade deficit and Japan’s surplus continued to grow. The “strong” yen wasn’t benign, however. It created a monster of a problem in Japan — a deflationary slump.

Today, the U.S. trade deficit is almost double what it was five years ago. This time around China is the fingered culprit; it accounts for almost 25% of the deficit. To deal with China, Washington has dusted off the same defective game plan used to bash Japan.

Senators Charles Schumer (D., N.Y.) and Lindsey Graham (R., S.C.) have led the mercantilist charge on Capitol Hill. They claim that China manipulates its currency, the yuan. As a result, the yuan is undervalued and Chinese exports are subsidized. To correct for China’s alleged unfair trade advantage, Senators Schumer and Graham have sponsored currency revaluation legislation and the Senate has agreed to give it an up or down vote by July. If it becomes law, the Chinese would be given six months to negotiate a yuan revaluation with the U.S. Absent a satisfactory revaluation, all China’s exports to the U.S. would be slapped with a 27.5% tariff — a rate equal to the alleged yuan undervaluation.

Not to be outdone, members of the House have also laid the U.S. trade deficit at the yuan’s doorstep. Congressmen Duncan Hunter (R., Calif.) and Tim Ryan (D., Ohio) have introduced the China Currency Act. It defines “exchange rate manipulation” as a “prohibited export subsidy” which, if deemed harmful, would — under Article VI of the General Agreement on Tariffs and Trade — trigger an antidumping or countervailing duty to offset the “subsidy.” Furthermore, if currency manipulation injured the U.S. defense industry, the importation of Chinese defense products would be prohibited.

The clamor for a yuan revaluation is loud. At one time or another, everyone from President Bush to the G-7 has had a hand in the noisemaking. But the yuan quick fix might just be neat, plausible and wrong. Let’s investigate:

– Does China manipulate its currency? It is not possible to give a categorical response to this question because “currency manipulation” is simply not an operational concept that can be used for economic analysis. The U.S. Treasury admitted as much in a March 2005 report that attempted to clarify the statutory meaning of currency manipulation for the Committees on Appropriations.

– Is the yuan undervalued vis‐​a‐​vis the dollar? No. The nominal yuan/​dollar rate has been set in stone at 8.28 since June 1995. Adjusting for inflation in China and the U.S., the real value of the yuan has depreciated by only 2.4% during the last decade. And today the yuan is in equilibrium in the sense that China’s inflation rate has converged to the U.S. rate. Not surprisingly, the IMF’s most recent Country Report on China concluded that “it is difficult to find persuasive evidence that the renminbi [yuan] is substantially undervalued.”

– Would a yuan revaluation reduce the U.S. trade deficit? Not much, if at all. After a yuan revaluation, the U.S. demand for foreign goods would simply be shifted from China to other countries.

– Would the House and Senate bills comport with international agreements and U.S. obligations? No. The yuan revaluation required by the Schumer‐​Graham bill would violate China’s rights and sovereignty. Under the IMF Articles of Agreement (Article IV, sec. 2(b)), a member country is free to choose its own currency regime, including a fixed exchange rate. The bill’s revaluation mandate would also throw a wrench into what has been an incredibly successful economic performance. Over the last decade, China avoided the great Asian financial maelstrom of 1997–98 and has realized stable prices and an annual growth rate of over 9%. The yuan’s fixed exchange rate against the dollar has provided the linchpin for that outstanding record.

According to Nobelist Robert Mundell, who is honorary president (along with Xu Jialu, vice chairman of the Standing Committee of the People’s Congress) of Beijing’s Mundell International University of Entrepreneurship, a substantial yuan revaluation would cut foreign direct investment, cut China’s growth rate, delay convertibility, increase bad loans, increase unemployment, cause deflation distress in rural areas, destabilize Southeast Asia, reward speculators, set in motion more revaluation pressures, weaken the external role of the yuan and undermine China’s compliance with World Trade Organization rules. In consequence, a forced revaluation would violate Article IV, sec. 1(i) of the IMF Articles of Agreement, which states that a member shall “endeavor to direct its economic and financial policies toward the objective of fostering orderly economic growth with reasonable price stability.”

If China failed to revalue the yuan, the across the board 27.5% tariff triggered by Schumer‐​Graham would violate China’s Most Favored Nation status under Article I of the GATT. Both the tariff and import prohibition features of the Hunter‐​Ryan China Currency Act would also violate the MFN treatment of China and would be ruled illegal by the WTO.

– Would it be in China’s interest to revalue and get the U.S. politicos off its back? No. The effect of a yuan revaluation — deflation and recession — would even be more damaging to China than trade sanctions. We estimate that a 25% yuan revaluation against the dollar would result in a deflation of at least 15%. China would be forced to relive the terrible economic conditions induced by the 1930s yuan revaluation. In 1934, the U.S. Silver Purchase Act monetized silver. This effectively revalued the yuan by 24% because China was on the silver standard. The price of the yuan against the dollar went from 33 cents at the end of 1933 to 41 cents in 1935. As Milton Friedman concluded in his classic study “Monetary Mischief”: “Because silver was China’s money, the rise in the price of silver had produced a major deflation, which in turn had led to severely troubled economic conditions.”

It’s time for the U.S. to stop rushing to judgment based on false premises. Antagonizing the world’s most populous country — and doing so by illegal means to boot — is both irrational and dangerous.

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