SPEAKING FREELY
Revaluation: A dangerous distraction?
By Sheetal K Chand

Speaking Freely is an Asia Times Online feature that allows guest writers to have their say. Please click here if you are interested in contributing.

Washington's pressure on China to revalue its currency is strongly supported by countries such as those in the European Union whose currencies are appreciating relative to the US dollar. This is understandable, but is it appropriate? Or is the furor over the yuan simply a distraction that is diverting attention from fundamental flaws with the present dollar-based international monetary system - the biggest flaw being that such a system enables the dollar-issuing country to postpone adjustment?

The nostrum from Washington is unequivocal: the yuan should be market-determined, which will enable it to find its true competitive value at a presumably more appreciated level. But what do we mean by market determination? Has the euro, for instance, found its true competitive value?

Exchange rates are unlike ordinary commodity prices. An exchange rate is the price at which one money exchanges for another, and thus has a forward-looking, asset related dimension. If people want to hold more of the currency because they expect it to gain in value, or they wish to acquire more assets denominated in that currency, they will drive up its market value, irrespective of the level needed to clear purely trade-related demands for foreign currency. This results in a fundamental conflict between the requirements of production and trade, and asset holding considerations. This tension is masked when the exchange rate is fixed, with occasional open eruptions. However, floating the exchange rate does not resolve the inherent tension. It simply gives way to the more dominant asset-side influences.

One just has to view the widespread gyrations in the dollar exchange rates of many important currencies to find that they bear no relation to underlying production cost movements. For example, the appreciation of the euro of some 60% vis-a-vis the dollar over the past few years can in no way be justified by divergent productivity trends. If anything, the greater productivity improvements in the US should have moved exchange rates in the opposite direction.

Emerging economies can ill afford such wild gyrations of their exchange rates while they are trying to develop their productive sectors. They lack the hedging capabilities of mature industrial economies, whose firms are able to mix the currency composition of their production and financing activities so as to minimize the effects of exchange rate movements. A stable exchange rate environment is more conducive to economic development, but how can this be feasible if the asset side, especially involving volatile capital movements, is unregulated as in a free market?

But even if the yuan is not floated, should it not be revalued? Would this not ease the burden on other countries of the allegedly supercompetitive yuan? The answer to this question depends on how effective exchange rate realignments are in bringing about a redistribution of trade. One merely has to look at the bilateral trade balance between Japan and the US, which remains massively in favor of the former, despite a sustained secular appreciation of the yen.

Many studies demonstrate that the textbook paradigm of a revaluation changing the production and consumption mix does not hold. Market segmentation and pricing to market is widespread. Multinationals frequently account for a large part of trade flows, and organize supply chains to maximize their strategic advantage. A multinational that supplies a department store chain in the US with utensils, say, is unlikely to shift production from China to the US just because the yuan has appreciated even by a large amount. It would most likely absorb any reduction in profits that ensues. These will in any case have been cushioned through a reconfiguration of production and exploitation of the scope for cost savings on dollar-denominated imports such as raw materials. The revaluation of the yuan serves merely to increase profits of firms engaged in competing lines of production in the US and the EU, who will now find it easier to raise prices. This will, of course, be at the expense of their consumers.

The huge trade surplus that China has with the US may not be as problematic as it appears when sitting in Washington, since China has large deficits with many other countries. China has been accumulating huge foreign exchange reserves, but a significant part of these represent capital inflows. If one excludes them and also net foreign direct investment inflows, since the latter are also an asset exchange - namely, an infusion of foreign exchange to acquire a domestic asset representing future production capacity - the amount of reserve accumulation that represents purely mercantilist motives is likely to be small. How, then, can one conclude that the exchange rate is undervalued?

Even if China were to disappear from the face of the earth, the US deficit would not shrink: it would merely be shifted to other countries. The root cause of the problem is not deficient consumption on the part of China but excessive US consumption, and raising the prices of Chinese wares is not going to solve that problem. Household saving rates in the US are extremely low, hovering at the historically unprecedented level of less than 1% of GDP. Taking household fixed investments into account, mainly in residential housing, this sector is in substantial deficit. When combined with the large fiscal deficit - the corporate sector is more or less in balance - a big current account imbalance results. The only sound remedy is for households to save more and for the fiscal deficit to be substantially reduced.

Chairman Greenspan, while calling for a flexible yuan, is at the same time highly aware of the need to reduce domestic imbalances. He contends that the private sector will eventually reduce its excess consumption as its becomes more indebted, but that appropriate discretionary attempts will be needed to curb the fiscal deficits. He puts the responsibility for addressing the US balance of payments deficit on others. Yet his role has been central. The Fed has kept interest rates at historically low levels over a considerable period. After adjusting for taxation and inflation, interest rates are significantly negative in real terms. This encourages borrowing but discourages savings. The resulting stimulative effect on consumption and investment is further compounded by balance sheet effects.

Discounting the future expected stream of earnings on an asset at a much lower interest rate results in a huge upward asset revaluation. An obvious beneficiary has been the stock exchange, but so has real estate, with home values almost doubling in the past five years. This has also influenced the composition of investment in favor of less productive residential construction. Coupled with the remarkable ease with which traditionally illiquid assets such as housing can be tapped for their perceived higher equity value, it is not surprising that there has been a tidal wave of refinancing and second mortgages. The vast majority of Americans have enjoyed low interest rate-induced upward asset revaluations, which are bound to delay their resumption of saving. And yet a higher savings rate from the current generation is badly needed if they are to cope with retirement needs as they age. Setting real interest rates at a suitable positive level would have provided appropriate signals. But this has not been done.

The US economy is in a quandary and Greenspan is now gradually increasing interest rates at a "measured pace" so as to give transactors time to adjust and avoid precipitate decisions. It is a delicate balancing act, given that the economy has become so highly leveraged as a result of the incredibly low interest rates and expansive monetary policy. A sharp upward jerk in interest rates could bring the whole house of cards crashing down. However, increases in the Federal Funds rate of only 0.25% on each occasion appears to have resulted in little, if any, adjustment, judging from the continuing escalation in real estate prices. Much more adjustment is needed and this will be unavoidably painful. The temptation is to try to export as much of the required adjustment abroad as possible.

US authorities often argue that the reason for their large deficit is rapid growth in the US. If only the rest of the world would grow faster and at the same time appreciate their exchange rates vis-a-vis the dollar, much of the problem would disappear. Exports from the United States would boom, imports would be restrained, while profits would rise. The last is especially important to offset any adverse effects on investment of rising interest rates. The stimulus from higher trade would also make it easier to pursue fiscal retrenchment and counter skepticism over current budget improvement proposals.

However, this is wishful thinking. An appreciating exchange rate is contractionary for the EU, which, with its self-imposed restrictions on the stimulative use of fiscal policy, can do little to promote faster growth in the short to medium term. China is already growing rapidly and sucking in imports. Revaluing the yuan would dampen its growth and may not result in an increase in its imports. But even if higher growth elsewhere is not forthcoming, an appreciation of other currencies vis-a-vis the dollar is still a highly attractive alternative to engaging in painful domestic adjustment. A booming economy could then continue to live beyond its means financed by dollars which cost virtually nothing to produce. If the rest of the world holds these dollars, the day of reckoning is postponed, and if the dollar devalues the US obtains a free lunch. This is of course at the expense of others, such as China, which would suffer a massive capital loss on its holdings of dollar-denominated assets.

To ensure such gains, the US Congress is threatening punitive tariffs of 27.5% on imports from China if the yuan is not revalued. Since most of the imports are likely to occur anyway, the principal risk for China is that it would lose profits and revenue. A preemptive response on its part would be to impose duties on its exports. A better solution would be to internalize the environmental and other externality costs associated with the rapid growth of the productive sectors in China in the form of fees or taxes for conducting business. These would be reflected in higher export prices and help defuse perceptions that China's exports are too cheap, while keeping revenues at home and avoiding the capital loss that could result from freeing the yuan.

It is questionable whether any punitive tariffs that might be applied to China's exports, on the grounds that it has been manipulating its exchange rate, would be legal. China has operated its fixed exchange rate regime in full compliance with its obligations under the IMF's articles of agreement. To be accused of manipulation when all one is doing is maintaining an agreed peg appears bizarre. The real manipulation that is taking place involves the sequestration of the world's surpluses though the medium of the present dollar-based international monetary "non-system". It is time for a root-and-branch reform.

Dr Sheetal K Chand is an independent consultant and guest researcher at the Department of Economics, University of Oslo, Norway.

Speaking Freely is an Asia Times Online feature that allows guest writers to have their say. Please click here if you are interested in contributing.