Chinese Foreign Economic Policy

Despite being lead by the Chinese Communist Party, The People's Republic of China has gradually liberalized its foreign economic policy since 1978 and the rise of Deng Xiaoping. Before the mid 70's, the PRC was relatively autarchic, largely due to Chinese isolation after the Sino-Soviet split and the Cultural Revolution, when China suspended all diplomatic ties. In 1978, Deng Xiaoping started his policy of "Reform and Opening up" which started the gradual transformation of China's economy from relative autarchy and central planning, to an open, liberal, free market economy. In 2001, China became a member of the WTO, and recently China has become the second largest economy in the world, behind the United States.

China's Foreign Monetary Policy

Up until 2005, China maintained a fixed exchange rate regime, pegging the value of the Renminbi to the US Dollar. In July of 2005, the People's Bank of China announced that it would remove the Reminbi's peg against the dollar, and allow its value to be determined by a basket of currencies which included the Euro, the US Dollar, the Japanese yen, and the South Korean won, among others. In the three years that followed, the value of the yuan rose by 21%. Then in July 2008, the China's central bank reinstated the peg to the dollar in response to the deepening of the global financial crisis, especially in the United States. This move was likely done as a caution against large capital flows that could destabilize China's economy, a lesson that China by watching the rest of Asia learn during the Asian financial crisis of 1997-1998. Chinese policy-makers attribute the fact they were largely unaffected by this crisis to their currency peg. Until June 2010, China maintained its currency peg by buying US Dollars and maintaining its capital controls that limit the convertability of the yuan, slowing down any "hot capital" that could potentially destabilize their economy. Then on June 19, 2010, in a move seen largely in response to pressure from the United States to revalue the yuan, the People's Bank of China again announced that it discontinue the Renminbi's peg to the dollar and resume its highly managed float based on a basket of currencies.

Under the new regime, every morning, the PBOC sets a dollar parity for the yuan, and allows it to be traded relatively freely; it is prepared to allow the yuan to rise by 0.5% in a single day. Of course, this is a managed float, and the PBOC has "corrected" for the effects of supply and demand on many occasions. On the first day of trading after the yuan became unpegged, its value rose 0.4% against the dollar, a rate at which its value would have doubled after 174 days. However, the next day, Chinese state-owned banks stepped in by buying dollars, pushing the yuan's value down again. This new exchange rate regime still has a highly managed character to it, allowing critics to say that this is largely a superficial change made for political purposes, and that the PBOC can still manipulate the yuan's value to protect domestic interests. To date, the value of the RMB has risen by about 2%. The PBOC currently holds over 2.4 trillion dollars in their foreign reserves that have accumulated from (previously) maintaining their peg and from managing the current float. 

The controversy surrounding China and The United States' Balance of Payments and the Renminbi

China currently maintains large surpluses in both its capital and current accounts. In 2008, the most recent published data, China had a current account surplus of about 426 billion US Dollars, and a capital and financial accounts surplus of about 19 billion US Dollars. Many critics in the United States argue that China's undervalued currency is protecting exporters, plays a large part in the massive US current account deficit, and is undermining the United States' efforts to recover from the current recession. Paul Krugman, an economist at MIT who won the Nobel Prize in 2008 for his work on international trade, argues that China's cheap currency acts as a subsidy for Chinese goods, allowing them to flood western markets, and giving them an unfair competitive advantage in international trade. Furthermore, this manipulation is undermining the global recovery because many economies are stuck in a liquidity trap, which means because interest rates are so close to zero, monetary policy is ineffective in stimulating aggregate demand. Thus, according to Krugman and others, "China, by engineering an unwarranted trade surplus, is in effect imposing an anti-stimulus" on western economies. 

Thus, Krugman and other critics of China's currency policy largely follow John Maynard Keynes's explanation of the causal chain that creates BoP imbalances, namely that the balance of trade influences patterns of savings and investment, which creates macroeconomic effects. In this case, because monetary policy is ineffective in a liquidity trap, and fiscal stimulus is no longer a viable political option, one way for the US to recover from the current recession is through increasing net exports. An increase in net exports can be accomplished by either reducing imports or increasing exports, or both. High demand for cheap Chinese goods should create upward pressure on their exchange rate, and allow the balance of payments to re-balance, increasing net exports, and helping the US recover from the recession. But because the renminbi is still significantly undervalued, it creates Krugman's so called "anti-stimulus" by interrupting this natural mechanism. Many critics of China's currency policy also point out that increasing the renminbi's flexibility would help the Chinese as well, by giving policy-makers better control over inflation, while the an increase in their currency's value will help rebalance the Chinese economy by shifting focus away from an export heavy economy, to one with more consumption and services. At the same time, an increase in the renminbi's value gives the chinese consumer more purchasing power internationally.

However, fixing the US and China's imbalances is not as simple as appreciation of the renminbi. Others follow Doug Irwin's perspective, saying that macroeconomic policy should be used to influence patterns of savings and investment, which will fix the giant trade imbalances, and that it was poor US macroeconomic policy (monetary policy), that created the imbalances in the first place. Many say that appreciation of the renminbi will create huge lay-offs in China's export industry, thus decreasing, instead of increasing, consumption. While a stronger currency may indeed help, these critics say, China instead should focus on the root problems of its high domestic savings rate, namely improving its social safety net, liberalizing to allow more small firms to compete with state owned firms, and better corporate governance to stop firms from hoarding cash and instead spread that wealth to the rest of the economy. 

See References for Citation, used under fair use.

Furthermore, the yuan's ties to trade are increasingly unclear. Fred Bergsten, director of the Peterson Institute for International Economics, testified to the US House Ways and Means Committee, saying that an increase of the yuan's value of 20-25% would decrease the US current account deficit by 50 billion dollars, decrease China's current account surplus by 350 billion dollars, and would generate 500k US jobs. However, the last time Chinese monetary authorities allowed the yuan to rise, the US trade deficit actually increased (see chart). So, it is clear that while the yuan's value has some impact on trade, the extent to which it affects trade, and what other factors affect trade are unclear. Indeed, as Stephan Roach points out, "in a highly competitive world, there are no guarantees that currency shifts would be passed through to foreign customers in the form of price adjustments that might narrow trade imbalances". 

Others are downright against allowing the yuan's value to rise. Most obviously, Chinese factory owners have a direct stake in the yuan's value, as any appreciation would decrease sales. Paul Kennedy, a history professor at Yale, argues that allowing the yuan to appreciate would hurt the US by decreasing the dollar's purchasing power on the international market, thus allowing China to buy more strategic raw materials, such as heavy earth metals required for advanced military technologies. As a result, US military power and security would be compromised.

Documents

• Read Fred Bergsten's Testimony to the House Ways and Means Committee here.