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For several years, the Chinese leadership has been inundated with United States’ demands to revalue the Yuan. During the Bush Administration, in April 2005, the United States Senate voted with a 67-33 margin, across party lines, threatening China with a 27.5 percent import duty to revalue its currency within six months.
According to economic analysts, the heightened pitch of United States’ complaints was partly due to the boom in textile imports from China, following the expiration of the Multi-Fibre Agreement (MFA). Since then, even Europeans who had been quite agnostic about the United States’ crusade against the Yuan, have come on board as their account surpluses with China are slowly turning into deficits. But the Obama Administration, the United States Congress and anyone else interested in jumping on this rapidly accelerating bandwagon would be well advised to check the course ahead since they are heading downhill without brakes.
A few days ago, on August 11, 2015, the People’s Bank of China lowered the Yuan’s exchange rate by almost 2 percent. The central bank’s move pushed the Yuan’s “daily fix” to 6.2298 against the U.S. dollar. This move was the biggest one-day change since China had somewhat loosened its dollar peg back in June 2010. As a result, financial market observers immediately jumped into two “conclusions.”
The first conclusion stipulated that, while China’s central bank paid lip service to a more flexible exchange rate regime in its announcement of the move, its action really signaled panic about China’s slowing growth. Others concluded that this devaluation was not a one-time shot, but rather the likely start to a prolonged period of engineering the Yuan’s downward turn, in a resolute effort to increase China’s external competitiveness.
As news of devaluation spread, all China-sensitive asset prices such as oil, copper, shares of luxury manufacturers, and emerging-market currencies dove below their already-depressed price levels. While the markets’ reaction reflected a lot of “first world” frustration, it is imperative to look at China’s recent move from a non-Western-centric perspective. As Helmut Reisen, a noted German economist stated, viewed from this angle, the market reaction and commentary seen to date is myopic. Even if the devaluation signals concerns about China’s current growth path, correcting the Yuan’s accumulated overvaluation will be good for China’s and other emerging countries’ growth as well as commodity and luxury exports.
According to Helmut Reisen, this may sound like a bewildering thought in the context of the still-dominant Western opinion. But in the new world we live in, two facts of life stand out. First, how China’s economy fares and, by extension, how other emerging markets fare, accounts for a far more significant share of humankind than the effects on Western countries. Second, Western markets and especially those in the U.S., are already way too “mood-dependent” on events in China. Particularly worrisome is the rather passive mindset, especially pronounced in the United States, that “China will be fine, so that we don’t have anything to worry about.”
Some may still doubt that the Yuan is overvalued. But let us look at the evidence. According to the broad measure of the Bank for International Settlements’ effective (i.e., trade-weighted) exchange rate, the Chinese Yuan has appreciated by some 30 percent over the past five years. And according to Barclays’ behavioral equilibrium exchange rate model, the Yuan remains the second-most overvalued currency in the world, by more than 20 percent.
As the Yuan stayed on a soft peg to the dollar, the U.S. dollar’s recent ascent has pulled the Yuan away from other currencies, leaving it increasingly overvalued. Even the Peterson Institute, traditionally regarded as the United States Treasury’s ventriloquist, prone to accusing China of unfair exchange-rate protection, has recently calmed down. It now gauges China’s so-called fundamental equilibrium exchange rate as “correctly” valued, at around 6 Yuan per dollar.
A further indication of the Yuan’s overvaluation, not undervaluation, as is widely charged in the confines of the United States Congress, is that markets as well as Chinese corporations had been expecting a Yuan depreciation going forward. As explained by Financial Times evidence of this is the surge of onshore foreign exchange deposits in China in 2014, largely due to corporations holding more of their export proceeds in foreign currencies.
What about the critical linkage of China’s economic fortunes to those of other emerging markets? It is largely ignored that China is the world’s most efficient country in turning its currency depreciation into higher growth, and by extension, world growth.
According to estimates by Harvard economist Dani Rodrik, a 10 percent nominal effective appreciation of the Yuan would lower China’s annual growth by 0.86 percentage points. Thus, the 30 percent appreciation which occurred over the past five years may have trimmed 2.5 percentage points off China’s growth rate. This reduction in China’s growth has translated into slight GDP growth in poor countries. Research by the OECD about growth linkages between China and poor countries has produced growth sensitivity estimates of 0.34 percent. Consequently, a drop of 2.5 percentage points in China’s growth rate is estimated to undermine developing countries’ annual growth by a percentage point.
According to Dani Rodrik, the growth link between China and the emerging markets was even higher, with one percentage point of growth in China translating into 0.66 percentage points of growth in the emerging markets. These macroeconomic mechanics of growth can constitute a certain degree of optimism for future economic growth in China and emerging countries as well as for commodity prices and world trade. This is of course, provided that the People’s Bank of China follows up its 2 percent devaluation on 11 August, with further devaluations.