What the renminbi revaluation reveals
Major economic machinations lurk beneath the realignment of the Chinese and American currencies.
The revaluation of the Chinese renminbi (also known as the yuan) against the American dollar last month was a lead story in the financial media, and the subject for copious analysis pieces. This currency realignment can only be understood in relation to two key and related developments in the world economy in recent years. First, the growth of huge ‘imbalances’ – most strikingly, between Asia and America. Second, the rise of China as a substantial economic power.
The shift in the renminbi’s value against the dollar was small, at least initially. After 11 years during which the renminbi’s exchange rate was fixed at 8.28 to the dollar, it was devalued by two per cent to 8.11 on 21 July. China’s central bank, the People’s Bank of China, also said that it would allow the renminbi to move a maximum of 0.3 per cent a day against the dollar – opening the way for a more substantial revaluation over time. In addition, the People’s Bank said that in future it would manage the exchange rate of the renminbi against a basket of currencies (it didn’t specify which), rather than the dollar.
Over time the system could change more substantially. According to the central bank’s official statement: ‘The People’s Bank of China will make adjustment of the RMB exchange rate bank when necessary according to market development as well as the economic and financial situation.’ (1)
In the short or medium term there are many reasons why exchange rates can fluctuate. However, longer-term shifts, and changes to exchange rate regimes, usually reflect broader economic and political changes.
In recent years America has become evermore reliant on Chinese economic support. The USA is consuming substantially more than it is producing; therefore, to keep going it has to borrow money from abroad. So the single most important global economic imbalance is the American current account deficit – the US imports substantially more than it exports.
Conceptually this is not that different from an individual using credit. Say someone earns £25,000 a year but spends £26,500; he can maintain his lifestyle as long as he can borrow £1,500 annually. If he cannot get the required credit he will have to make an adjustment to his lifestyle to bring it in line with his income. Add several noughts to the figures – America’s GDP is $12.4trillion and its current account deficit for 2005 is forecast to be $724billion – and the picture looks similar (2).
Of course, there are important differences between individuals and countries. In particular, America is the world’s largest economy and its currency, the dollar, is by far the most important international currency. This means that other countries have an interest in shoring up the American economy as long as it does not reach the stage where such action starts to hurt them.
It is precisely such a ‘marriage of convenience’ that has emerged between America and China in recent years. America needs Asian capital to help cover its current account deficit; this generally takes the form of Asian central banks buying bonds issued by the US Treasury. In return, the US continues as a key market for the export-orientated economies of Asia.
In effect, China – still a relatively poor country in terms of income per head – is subsidising its exports to the richest country in the world. By buying American government debt, it is helping to keep US interest rates artificially low. This means in turn that American consumers have had more money to buy Chinese goods.
Perhaps surprisingly, America has moved to start loosening this relationship before China did. The Bush administration was putting substantial pressure on China to revalue the renminbi to head off increasing protectionist pressure within America. Although America as a whole was benefiting from the Chinese subsidy, some US producers were increasingly complaining about Chinese competition. American protectionists hoped a renminbi revaluation would make China a less formidable competitor, since Chinese exports would be more expensive in dollar terms.
This brings us to the other reason why the dollar-renminbi relationship is so important to watch. Over the past five years China has emerged as an important player in the global economy. If it was not for China’s economic dynamism, the marriage of convenience between America and Asia could not have lasted for so long.
Although the Chinese economy has grown rapidly since the late 1970s it was only in the early 2000s that it began to have a significant impact on the global economy. The global economic slowdown at the start of the decade would have been more severe if China had not been growing so fast. As the Organisation for Economic Cooperation and Development’s Economic Outlook argued in May 2004: ‘The relatively limited downward amplitude of the present cycle is partly related to the buoyancy of economic activity in Asia, and especially in China, early in the recovery.’ (3)
It’s tricky to measure the importance of China in the global economy. If we look at purchasing power parity – taking into account relatively low prices in China – the country accounts for just under 14 per cent of global output. However, if measured at current prices, China accounts for about four per cent – just slightly less than Britain (4). In many ways the latter is a better measure of China’s global weight because trade and investment are conducted in current prices. But this underestimates China’s importance. In a world economy that is growing relatively sluggishly, an economy that is expanding at between eight and nine per cent a year will have a disproportionate impact.
There are other reasons why China, with its population of 1.3billion, is important to watch. A high proportion of China’s output is geared towards industry – in contrast to most Western countries, where the emphasis is on services or finance. China is heavily involved in productive activity, rather than relying on financial institutions to skim a share from global output. In addition, China is the world’s third largest trading power after America and Germany (5). Mainland China is increasingly integrated with the other developing Asian countries around it.
In recent years, subsidies from China, still a relatively poor country, have enabled America to live beyond its means. This represents a temporary convergence of interests, but there are also tensions. China’s attempt to buy Unocal, a medium-size American oil firm, and its purchase of the personal computer business of IBM, have stirred protectionist sentiment in America (6). The Pentagon has also recently published an anxious report on China’s growing military strength (7). In addition, the Bush administration has started cultivating India, Asia’s other demographic giant, as a strategic counterweight to China. In July, India’s prime minister Manmohan Singh became only the fifth world leader to be accorded a state visit to Washington under George W Bush (8).
It is likely that the America-China relationship will become even more important to watch in the years to come. The realignment of the two currencies is likely to be only the start of a shifting relationship between the two sides.
(1) Public Announcement of the People’s Bank of China on Reforming the RMB Exchange Rate Regime, 21 July 2005
(2) Figures from the International Monetary Fund World Economic Outlook database, April 2005
(3) OECD Economic Outlook, May 2004, p11
(4) Figures from the International Monetary Fund World Economic Outlook database, April 2005
(5) International trade statistics 2004, World Trade Organisation
(6) ’The dragon tucks in’, Economist, 30 June 2005
(7) ’Sizing up the dragon’, Economist, 21 July 2005
(8) ‘Indian Dream’, Sunil Jagtiani, Fund Strategy, 1 August 2005
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