Yuan: Dissecting the Geithner Argument

Given the global economic turmoil at present, the US has been putting political pressure on China to change their policies. The US treasury secretary Timothy Geithner feels that in undervaluing the Exchange rate, China is able to ‘dump’ their cheap exports and drive out competitors, and this is an underlying factor behind the burgeoning US-China bilateral trade deficit. This argument is simply bad economics!

The bilateral trade deficit argument is wrong on the basis that, given the US’s savings-investment imbalance is unchanged with the rest of the World, if the trade deficit between US and China is reduced (and the corresponding net capital inflows from China into US is reduced), then there must be a corresponding increase in net capital inflows into the US from countries other than China. Thus, the US dollar must appreciate against these other countries in such a way that the trade deficits with these countries are increased in a compensatory manner to the reduction in the US-China trade deficit. This is based on the assumption that a change in the Yuan-US exchange rate has no effect on the Savings-Investment imbalance of the US with the rest of the world.

The best counter against Geithner’s argument is to realise that trade flows are ultimately dependent on real exchange rates. Knowing that the undervalued Yuan is simply a form of monetary policy, it cannot affect real outcomes in the long-run. Thus, one should not look at the undervalued Nominal Yuan, but that internal price adjustments matter as well. Trade flows, and hence the real exchange rate, are dependent on international competitiveness, technology, tastes and endowments of labour and capital.

Furthermore, as mentioned in my Yuan: the implications of a revaluation, the fact that Geithner suggests the Yuan is undervalued is a red herring, in light of the uncertainty revolving around how the Yuan would adjust in response to an initial revaluation. The potential for a downward adjustment due to the removal of capital controls/removal of ‘hot’ speculative flows could lead to an even cheaper Yuan and a greater bilateral trade deficit.

A more positive way to view China’s monetary policy is to view the undervalued Yuan as the key to China’s export-led growth. By helping develop an export market, it has given time for the export industries to increase employment, output and achieve economies of scale. There is no such thing as a free lunch, and by undervaluing the Yuan China has had to cope with inflationary pressures. This internal price adjustment has been to keep a check on wages and align wage increases with productivity.

The floating of the Yuan is a natural transition as China becomes more competitive and market integrated. The floating of the ER can be an optimal response in light of ‘Contractionary Devaluations’ theory, which suggests that an appreciation of the Yuan can lower the domestic currency price of imports, and lead to a surge in demand for oil and coal. Such commodities are inputs to the production process of many Chinese Manufacturing firms, and the lower cost of production can come as a positive supply side shock.

A lot of ‘Geither’ type arguments are politically motivated and are aimed at appeasing the woes of American companies in direct competition to their Chinese counterparts. For example, Steel manufacturers in the US have to bear the burden of adjustment as they compete with the ‘undervalued’ exports. Geither simply neglects the millions of American consumers that benefit from receiving the cheapest possible steel of sufficient quality, which overwhelm the losses accrued by the select few in the US Manufacturing industry. Sure, it is not pareto-optimal…but in life most things rarely are! Economics is almost always about trade-offs, but in this case Geither looks at the negative aspect of the trade-off, completely neglecting the more powerful positive aspect.