Why Not Let the Yuan Rise?

Apparently Xinhua, the state news organ, the Chinese policymakers will refuse to let the yuan “blindly” appreciate against the dollar. On the surface their complaints that it is not right for one country to bow to the pressures from another country’s congress are right (though I think China should respect that a well-balance global market is one of the US’s “core interests”). The other objections are just the usual meaningless phrases for the Wu Mao to repeat on online forums. Though, when you think about it, there are so many great reasons for the Chinese to let the yuan rise versus the dollar that I’m not sure why they are so resistant about it.

Now yes, yes, I know that the government has been letting the yuan rise at a moderate rate against the dollar as you can see here in this graph:

source: x-rates.com

Of course, by just eyeballing this chart you can see the rate has been rather steadily at a snail’s pace, with appreciation pretty much stopping since the European crisis reached its heights in August and September. And this really only shows the nominal exchange when it is the real exchange rate that matters most in international trade. One good way of knowing if a currency is appreciating faster than the nominal rate is to look at inflation in each country. The great finance professor Michael Pettis wrote about this a few months ago in this post. I won’t go into the macro that much here since I think he does a much better job than I could in laying it out for you.

Instead, I’ll simply outline a few reasons why it might be in China’s favor to undertake a more rapid appreciation of the yuan.

First of all, it will improve relations with the United States. China is at a very pivotal moment in its history right now where the struggle between reformist thinking and entrenched interests will probably decide how the country fits into the world order. If China continues along the path it is currently on, it almost ensures to create unfriendly relations not just with the United States and its navy, but also its neighbors. Currently, the South East Asian countries are looking to the United States as a counterweight to the increasing confidence of China in its territorial claims. Since America already perceives China as a threat, it is more than willing to assist these countries if they ask so. China doesn’t make things any better by undertaking policies that go against the interests of the Americans. This isn’t to say that the Chinese should return to a policy of appeasement, but rather that they shouldn’t expect a warm welcome on the world stage if they continue their policy of agitating the world’s great powers.

More importantly, it will help China begin down the road towards rebalancing its economy. You’ll see occasionally pundits claiming that China’s twelfth five-year plan shows a commitment to lower growth and higher consumption, emphasizing the goal of 7% growth (contrasting that with the current 9-10% growth). If you do a little research, though, you’ll see that in China’s eleventh five-year plan the goal for growth was 7.5%. I’m not sure exactly how a drop in 1/2 of a percentage point is tantamount to a clear commitment to a more consumption oriented approach. However, a stronger currency versus the dollar is a great way to encourage more consumption, especially through imports. The great thing about imports is that they increase the total supply of goods and services available to an economy and thereby decrease the equilibrium price level. This means lower inflation in China.

Increasing imports would also tie back to the previous point about improving relations with the West. Western economies are desperately looking for demand to drive growth again and increased Chinese imports (given the massive size of the populace) could easily fill this void. China would become part of the solution instead of preserving its current economic regime. This is the very economic model that contributed to the global imbalances that plague the world today.

Allowing the yuan to rise too rapidly could also be a problem, but the longer China prolongs reform and readjustment of its economic model the more serious the costs will be. Right now increasing the purchasing power of the average Chinese is key to taming the inflation threatening households and to ensuring China’s transition to policies that are aimed at improving welfare rather than displaying power and prestige on the world stage.