Bogus arguments for RMB revaluation

By John Ross
0 CommentsPrint E-mail, November 27, 2009
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There is a hidden, implicit, assumption of those arguing that an increase in the exchange rate of the RMB will lead to a fall in China's trade surplus. This is that China's exports and imports move separately and are price sensitive – in formal economic terms that demand for them is independent and elastic. If these assumptions were factually true then, as the price of China's exports rose, due to an increase in the RMB's exchange rate, demand for China's exports would fall substantially while simultaneously as the price of China's imports fell, due to the same exchange rate shift, demand for imports would rise. But this combination necessarily assumes that the volumes of China's exports and imports move separately – as the relative volume of exports would be falling and the relative volume of imports rising.

The problem is that the facts indicate that this hidden assumption is false. An increase in the RMB's exchange rate did not lead to a major decline in China's exports but it did lead to a sharp fall in the value of China's imports.

The actual pattern after 2004 is easily explained if the truth is the opposite of the hidden assumption of President Obama's advisers. That is, if China's exports and imports do not move separately and demand for them is relatively inelastic. In that case, as RMB revaluation increases the price of China's exports while decreasing the relative price of its imports, an increase in the exchange rate of the RMB will increase China's trade surplus and not reduce it – exactly the pattern seen after the RMB exchange rate started to go up in 2005.

It is in fact rather easy to see why China's exports and imports do not move independently. China is the world's largest exporter. A vast amount of its imports are inputs to its export industries.

Therefore demand for exports and imports are not separate but move in parallel. Consequently, RMB revaluation puts up the price of China's exports while reducing the relative price of its imports – and therefore China's trade gap increased as the RMB exchange rate went up, explaining the post-2004 pattern.

What conclusions can we draw from this? If we study the factual trends in China's trade, the consequences of RMB revaluation against the dollar could be very unpleasant for the rest of the world.

We can assume that increasing prices would slow demand for China's exports somewhat, if not a great deal, and that China's demand for imports would slow in parallel. China's trade surplus would again rise, primarily due to the falling value of China's imports. Overall, this would reduce the beneficial, "locomotive" effect that the relative increase in China's imports has had on a series of countries during the financial crisis.

That a rise in China's export prices relative to its import prices would be adverse for major commodity suppliers, such as Australia or Brazil, is unsurprising. But the trade data shows the effect would spread far more widely internationally.

If the arguments presented for RMB revaluation by the US administration have no factual basis, why are they being put forward? The real answer lies not in trade but in debt – as other writers, such as Daryl Guppy, have rightly pointed out. In asking for RMB revaluation, President Obama's advisers were, in effect, asking China to donate $150-$300 billion in RMB to the US via debt reduction.

The arithmetic of this is simple. China's holdings of US dollar assets, chiefly Treasury Bonds, are around $1.5 trillion, or 10.2 trillion RMB. A 10 percent devaluation of the dollar vis-à-vis the RMB would reduce the value of these holdings to 9.3 trillion RMB, and a 20 percent dollar devaluation would reduce their value to 8.5 trillion RMB. In either case the U.S. is asking for its debt to China to be reduced by 10-20 percent in RMB terms.

It may now be seen why President Obama's advisers have a vested interest in not examining the factual situation of China's trade. They are seeking a large debt relief package. Other countries, however, do have an interest in examining the facts carefully – as they will not benefit from the debt relief but will suffer from the adverse trade effects.

Whether China wishes to grant debt relief to the U.S. is a bilateral issue. China will undoubtedly take into account many considerations before deciding whether to implement such a debt reduction package. As this concerns China's foreign exchange reserves, this is really an affair for the U.S. and China alone.

But what the US administration does not have the right to do is putting forward arguments for RMB revaluation that are factually incorrect. The U.S. might not suffer any short term negative consequences of RMB revaluation, due to the debt reduction effect. But other countries would. It is at this point that such arguments become not only false, but dangerous.

John Ross is Visiting Professor at Antai College, Shanghai Jiao Tong University. From 2000 to 2008 he was Director of Economic and Business Policy in the administration of the Mayor of London Ken Livingstone, a post equivalent to the current position of Deputy Mayor. He was previously an adviser to major international mining, finance and equipment manufacturing companies. 


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