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Early RMB revaluation would hurt the world economy

'Seek truth from facts,' a maxim originating from the Han Dynasty, was favoured by Deng Xiaoping. Regrettably it seems to have been ignored by many urging an early increase in the RMB exchange rate. They seem neither to have studied the facts nor grasped that, in the short term, revaluation of the RMB would increase China's trade surplus, the opposite of what the world economy needs as it recovers from the international financial crisis.

Paul Krugman's New York Times column urging trade sanctions against China claims 'the International Monetary Fund expects China to have a 2010 current surplus of more than $450 billion.' Even if an IMF statistician made such a claim, it is false – as Krugman could discover by checking the figures. China's annual balance of payments surplus, which includes not only trade but also services and income from abroad, is about $120 billion over its unadjusted trade surplus – which was $198 billion in 2009 and running at $180 billion in February 2010. Factually therefore, China's balance of payments surplus will not remotely reach $450 billion this year. The falling trend of China's trade surplus is shown in Figure 1.

Will Hutton claims in The Observer that China is 'increasing its reliance on exports.' Again, quite untrue; China's exports declined to 25 percent of GDP in 2009 from 35.7 percent in 2006 – as shown in Figure 2. Increase in domestic demand in China has led to a sharp decline in the weight of exports in GDP.

China's commerce minister Chen Deming gave an excellent survey of China-US trade in the China Daily. If Paul Krugman, Will Hutton and others want to engage in serious discussion they should therefore first get the facts right.

The RMB exchange rate is not just a bilateral question between the U.S. and China. As has been widely noted, revaluing the RMB would make China's exports more expensive – cutting living standards and creating inflationary pressures in the U.S., where 20 percent of imports come from China. But three quarters of China's exports go to other countries. Those urging early RMB revaluation are therefore arguing for pressure on living standards and for inflation to be transmitted not only to the U.S. but worldwide.

To understand how early RMB revaluation would damage the world economy we should also recall China is not only the world's largest exporter but also the fastest growing importer. Since the crisis, China's imports have provided the single biggest boost to other economies' external demand.

In annualized terms, between July 2008 and December 2009 OECD data shows US imports fell by $550 billion and China's imports rose by $100 billion. In the same period the US trade deficit shrank by $364 billion and China's surplus fell by $180 billion. The US therefore was subtracting $364 billion from international net demand while China was adding $180 billion.

Furthermore, while the U.S. explicitly aims to reduce its trade deficit – thereby reducing overall international demand, China's policy is to expand demand by boosting imports and cutting its trade surplus.

Since more than half of the goods China imports are inputs to exports, a cut in China's exports would lead to cut in its imports. This would hit countries like Japan, South Korea, Germany and Australia especially hard.

Those urging immediate revaluation argue that since China runs a trade surplus it should revalue the RMB. Unfortunately the second statement only follows from the first if factually RMB revaluation would lead to a reduction in China's surplus – it is not an issue of logic.

To see this, assume the RMB exchange rate went up 10 percent but China's exports fell by only 5 percent. In this case China's trade surplus would actually increase. For China's trade surplus to fall after RMB revaluation, changes in the volume of China's exports and imports would have to be sufficient to offset the fact that export prices would rise and import prices fall; in economic terms, the assumption is that demand for China's exports and imports is elastic. Krugman and Hutton make no attempt at all to demonstrate this – they claim it without proof. The reason they don't attempt to prove it is that in the short term, which is crucial for the world as it emerges from the financial crisis, it is almost certainly false.

A crucial point in this is to examine the effect of RMB revaluation over different time frames.

There is a large literature modelling the long term effect of increasing the RMB's exchange rate – with findings ranging from a reduction in China's trade surplus to an increase. But in the current circumstances this does not matter, as in the present extraordinary state of the international economy, it is crucial to pay attention to the short term – the next 6-18 months.

Over such a short time frame, we do not need to rely on theoretical models. The effects of such a revaluation have been seen in practice. Zhong Shan, China's commerce vice minister, noted: "From 2005 to 2008, the RMB appreciated by 21 percent against the dollar but China's trade surplus with the U.S. increased by 20.8 percent annually. Since 2009 the RMB exchange rate has remained basically stable, but China's surplus with the U.S. has fallen by 16.1 percent."

What occurred in 2005 to 2008, when China increased its exchange rate, is shown in Figure 3. This illustrates that over a three year period as the RMB's exchange rate increased China's trade surplus did not shrink. On the contrary, it rose.

The fundamental reason is that, as discussed in an earlier column, China's imports are in large part inputs into exports and therefore imports and exports do not move separately.

But even ignoring this fact, there is a well established short-term "J curve" effect regarding currency changes. When a currency's exchange rate changes, it takes time for demand to adjust. Revaluation increases export prices and reduces import prices and the "J curve effect" of an RMB revaluation would increase China's trade surplus in the short term. But even a short term increase in China's trade surplus would reverse the most significant source of world demand and deal a blow to the world economy as it struggles out of the financial crisis.

Timing is crucial for the world economy. In the medium to long term the exchange rate of the RMB should and will go up – the increasing productivity of China's economy makes it competitive at progressively higher exchange rates. But because an increase in the RMB exchange rate would put upward pressure on China's trade surplus in the short term, from the point of view of world trade it would be better if revaluation did not take place until the world recovery is more firmly established – on current trends likely to be closer to the end of this year.

Holding the RMB's exchange rate steady in the short term, while letting it rise in the medium/long term, has so far been the position of China's government. But it also happens to be in the best interests of the world economy.