Could China's exchange rate manipulations lead to crisis? Strong Revaluation of the Yuan Poses a Threat to the Stability of the Global Economy

The financial crisis recently demonstrated how dangerous global imbalances can be. At present, the global economy appears to be further from reducing trade imbalances than it was before the crisis. Some countries, including China in particular, have been accused of systematically manipulating the value of their currencies in order to enhance their economic competitiveness. Dr. Marcus Kappler, deputy head of the Growth and Business Cycles research group at ZEW, explains the problems associated with an undervalued yuan.

After studying economics in Tübingen (Germany), Maryland (USA), and Berlin, Dr. Marcus Kappler completed his doctorate in 2007 at Goethe University in Frankfurt am Main. Dr. Kappler has been at ZEW since 2002 and is the deputy head of the research group "Growth and Business Cycles". He primarily researches the accuracy of economic forecasts, structural unemployment, and the factors influencing production potential.

The United States has accused China of keeping the value of the yuan artificially low in order to augment its exports and domestic growth. Can we expect a revaluation of the yuan in the period ahead?

Kappler: Global exchange rate fluctuations have been caused in part by the expansionary monetary policy of the United States. The mere announcement by the Federal Reserve that it plans to continue its loose monetary policy has placed the dollar under pressure in foreign exchange markets. Furthermore, the economic situation in China has yet to stabilise; the country’s foreign trade deficit is likely to reach its peak in the near future. However, it is true that in June of 2010, the People’s Bank of China eased the close peg to the dollar and thereby took an initial step toward making the Chinese exchange rate system more flexible. As a result, there has been a very gradual strengthening of the currency against the dollar. However, further revaluation of the yuan is not an option currently being entertained by the Chinese. The global economy needs to pick up again before China can be expected to contribute to the elimination of global imbalances by adjusting its exchange rate policy. It would be detrimental if the current turbulence being experienced were to lead to protectionist trends in general.

Which countries are most affected by a weak yuan?

Kappler: Apart from the yuan, the Korean won, the Brazilian real, and the Argentinean peso are all undervalued. On the other hand, the US dollar and the euro are overvalued, resulting in knock-on adverse effects for the price competitiveness of exporters from the euro and dollar areas. The euro is already bearing the brunt of the devaluation in the dollar, as the central banks in emerging markets peg their exchange rates to the performance of the dollar through currency interventions. The ECB, by contrast, does not intervene in such a systematic way in foreign-exchange markets. Accordingly, the euro has already strengthened significantly against the dollar in past weeks. If this trend continues, it would act as a brake on German export growth and could negatively impact the recovery in Germany.

The United States is threatening to impose punitive tariffs on Chinese imports. Is that a solution?

Kappler: Penalising tariffs on Chinese imports would certainly be a drastic response to the Chinese government’s intervention in the exchange rate system. Nevertheless, the United States will most likely not carry out this threat, as this would trigger a dangerous spiral of reprisal measures. Apart from the legal issues involved in implementing such punitive action within the framework of the General Agreement on Tariffs and Trade, measures should be taken to reduce current account imbalances, thereby getting to the heart of the problem.

What should therefore be done to eliminate global imbalances?

Kappler: China’s current account surplus reflects a surplus of savings over investment. The high outflows of capital from China – primarily to the United States – guarantee the financing of current account deficits in other parts of the world. In order to eliminate these imbalances, one should intervene in capital markets rather than take actions which would disrupt international trade. Daniel Gros’ proposal to introduce capital account reciprocity would be a step in the right direction: Only if China opens its capital markets to foreign investors should China’s banks be allowed to make investments abroad – e.g. in foreign government bonds. Consequently, American government bonds would become less attractive for Chinese investors and the United States would become more reliant on the domestic financing of its national debt. This would help to eliminate imbalances.

The yuan’s exchange rate is pegged to other currencies – primarily to the dollar. What would happen if China were to float the exchange rate?

Kappler: It remains to be seen whether there will be a complete floating of the yuan. Nevertheless, economists remain divided as to whether this would help to eliminate the imbalances between China and deficit countries. Yet it should be clear that a strong revaluation resulting from a complete floating of the foreign exchange rate would increase the yuan-denominated debt burden on Chinese banks and state-owned enterprises, and thereby pose a threat to their stability. In a worst-case scenario, the Chinese financial system could experience a crisis, and this would undoubtedly have a considerable impact on the rest of the world.

Contact:

Marcus Kappler, kappler@zew.de

Kathrin Böhmer, boehmer@zew.de