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The US Cat and China’s Yuan- Part I

It seems a cat and mouse game. The reference is to the dispute between the U.S. and China over the exchange rate for the Yuan (renminbhi or RMB). It has gone on for nearly a decade now and is rather unending and tiring. Starting way back in 2001, it reached its crescendo (nadir?) in 2005. What looked like a bilateral dispute in early years, it got transmogrified into a contentious global issue over financial imbalances. Yes, you have guessed it. The villain is the Yuan.

When it started, it had all the froth and ferocity of a street play. Senators like Charles Schumer, Lindsey Graham and Charles (Chuck) Grassley would file bills in Congress proposing punitive tariffs on Chinese imports. (Schumer and Grassley are continuing with their games till date.) In 2005, there were more than two hundred Bills in Congress. Senators would also send joint letters to President and seek severe action against China to safeguard U.S.’ interests. Needless to add, a section of the manufacturing lobby would be in toe advocating sanctions and whipping up the public fury through the media.

There seemed to be a growing consensus in the U.S that China was at the root of all their ills, i.e. trade deficit, deindustrialization and growing unemployment. The charge was that China was able to steal the market by ‘manipulating’ its exchange rate. If only China could keep its exchange rate market determined, there would be global balance and peace and prosperity everywhere. There were economists from institutions like the Brookings, Peterson Institute of International Economics, Heritage Foundation, etc arguing that China’s Yuan was undervalued anywhere between 25 to 40 percent. Their assessment of the extent of undervaluation will vary depending on the models used and the assumptions made. Many of these practitioners had earlier stints in the IMF. Their attack was on Yuan’s peg with U.S. dollar which had remained fixed at 8.3 Yuan to a dollar from 1994. (Its official rate was 8.7 Yuan to a dollar while the nominal rate remained at 8.3).

The issue was truly complex and did not lend itself to rough and ready solutions. It was not admitted that other interpretations or approaches were possible. China could argue its case convincingly. It could cite many economists, including Nobel Laureates, in support of its exchange rate policy.

Disputes which deeply hurt vested interests revolve in self-perpetuating modes like yo-yos. The Yuan issue was no different. If the U.S. had its share of manufacturing lobbies and trade interests, China was pitted against its exporters and State-owned-enterprises (SOEs) on the one side and a growing number of experts in policy making bodies like the People’s Bank of China (PBoC). What was a bilateral dispute in the early years was transformed into a multilateral dispute. U.S. began to involve the G-7 to step up pressure on China. When G7 lost its clout in later years due to the Southern shift in global economy, especially after the eruption of the financial crisis in 2008, U.S. tried to bring G-20 into it. The U.S. also tried repeatedly to set the IMF on China in the garb of “surveillance” of exchange rates. These efforts petered out. (We deal with the IMF debacle in a later part of this piece).

China was unyielding to external pressures. On all occasions, in all meetings and negotiations, China maintained that while it was committed to moving towards “a flexible, market-based foreign exchange rate,” it would do so at a time of its own choice and would not take any decision under duress. In fairness, China did elaborate on the intractable problems facing its banking and financial sectors and how it could not reform only the exchange rate upfront.

The problem is that China deals with the Yuan rate issue organically and holistically as one involving its economic-cum-social stability along with developmental concerns. However, Western authorities, in particular those in the U.S., view it through a narrow monetarist prism. Further, China has also to safeguard regional economic stability as it has become the fulcrum of Asian manufacturing and trade.

China had rose up to its responsibility to the region during the Asian crisis of 1997 when there were competitive depreciations among Asian exporting countries. If China had not held on to the Yuan peg to the dollar, the crisis would have deepened and gone out of hand. President Bill Clinton undertook a special trip to Beijing to plead with them not to depreciate its currency. Though it had been decided upon independently by Beijing and not under U.S. persuasion, Beijing’s announcement that it would not depreciate the Yuan was proclaimed as a diplomatic coup by the U.S. State Department.

Governor Zhou Xiaochuan of the PBoC had articulated China’s role in and responsibility to the region in some of his speeches, including those made in the Annual Meetings of the Fund/Bank.

Rate changes have to be effected cautiously and gradually. It is no exaggeration to suggest that the Chinese authorities are obsessed with social and economic stability and they have their own reasons for the approach. However, Senators and US lobbies were turning impatient and could not wait longer.

As we noted in the beginning of this piece, the attacks on China had reached their crescendo by mid 2005. The Treasury issued a warning in its Currency Report of May 19, 2005, that unless China reformed its exchange rate, it would be liable for punitive steps. Senators Schumer and Graham tabled a Bill seeking to impose a 27.5 per cent tariff on all Chinese goods. It was a grim scenario. On 21 July, 2005, China surprised the U.S. and the world by announcing a major change in its exchange rate policy. It de-pegged Yuan from the U.S. dollar. It set the value of the Yuan against a basket of currencies. The Yuan was revalued by 2.1 per cent with an assurance that it would be adjusted in future as a “managed float” with changes “when necessary, according to market development as well as economic and financial situation.” It was truly a deft move and blunted much of the criticism over the Yuan’s peg to the dollar. Floating rates and crawling pegs are approved under the IMF Articles.

The Yuan rate came down from 8.7 Yuan in 1994, edging up to 8.11 Yuan per dollar in July 2005 and rising to 6.87 Yuan per dollar in 2009. The revised rate was allowed to move within a daily band of 0.3 per cent. (It was raised to 0.5 per cent in 2007.) It remained effective at 6.83. The U.S. Treasury was happy over the change in policy and informed Congress that China was on the mend. The Schumer-Graham Grassley Bill was deferred.

The decision taken in 2005 was a watershed. From a diplomatic point of view, it bought peace for China. It seems that they, especially the PBoC, view it as “the continuation of the reform in 1994.” In a speech delivered on 15 July 2010, Hu Xiaolian, Deputy Governor, PBoC, narrates the circumstances which led to the change.

There was an upswing in the global economy and China’s exports soared along with its foreign exchange reserves. By now, China had become more confident of its role in getting integrated with the global economy after its WTO accession in 2001. As she said, “Because of all these developments it was believed that it was the right time to further reform the exchange. On 21, July 2005, China improved the managed floating exchange rate regime based on market supply and demand with reference to a basket of currencies.” ( Strangely, in her speech, Ms Hu goes on to argue against rigid exchange rates and how they are not responsive to crisis and may even trigger monetary and financial crises! She seems to echo the views of foreign critics and economists about China’s exchange rate policies and the need for change. Their criticism is constructive and sympathetic to China and Chinese authorities were also realizing the value of their analysis.

Moreover, there are reports of on-going policy dialogues within China between various agencies such as the Ministry of Commerce representing exporters on one side and PBoC on the other side and reputed think tanks which are associated with policy making in recent years. There is also the report that the PBoC is a minor player and final decisions are always taken by the Communist Party of China (CPC). In any case, Governor Dr. Zhou Xiaochuan is an old hand and knows how to mediate between the PBoC and the CPP.

In retrospect, the change effected in 2005 brought a temporary truce lasting three years. From July 2005 to July 2008, the Yuan appreciated against dollar by 21 per cent. Sadly, this was not followed by any narrowing in U.S. trade deficit with China. China’s trade surplus continued to flourish. Foreign capital inflows also surged along side ‘hot’ money flows entering in anticipation of currency changes. PBoC resisted the temptation and pressures to hold back Yuan appreciation.

It has been assessed by researchers that during this period, China set the Yuan’s value based on a narrow range of fluctuation against a basket of currencies, including the dollar, euro, yen and won. Doubts crept in about the manner in which China operated its rate and what the weights were for the currencies in the basket. Of course, no country ever publishes these weights and they have to be inferred through detailed statistical analysis in later years. Thus, China cannot be accused of secrecy in doing it. However, doubts continued. Some analysts jibed that the Yuan was continuing with its peg to the dollar. Prof. Jeffrey Frankel of Harvard University has done detailed studies on the Yuan rate during these years. (See: 1. Implications of Yuan’s Return to Dollar Link, Seeking Alpha, March 12, 2009 and 2. “The renminbhi since 2005”, Chapter 7 in The U.S.-Sino Currency Dispute: New Insights from Economic, Politics and Law, 15 April 2010.) He noticed that there was tight peg to dollar after July 2005. “Gradually, in 2006, the relationship loosened. Statistical analysis suggests that the People’s Bank of China did indeed begin to assign a little weight within the anchor basket to a few non-dollar currencies, perhaps beginning with the Korean won during a period centered on January-March 2007. However, most of the weight remained on the dollar.” In the course of 2007, “the Yuan became eventually weighted between the dollar and the euro. In fact, the Yuan’s 20 % appreciation against the dollar over the next three years to 2008 mostly reflected the euro’s gain vis-à-vis the dollar.” (China Resumes Dollar Pegging on the Sly, Tina Wang, Forbes, 03.27.09).

By July 2008, PBoc had effectively moved back to dollar peg or rather was forced to get back to the peg. This was forced upon it by the financial crisis and the turmoil in the currency markets. With the U.S. stimulus in place and the U.S. Fed pumping trillions of dollars (printing!) dollar began to slide and many other currencies, especially in Asia, began to appreciate. Euro began to depreciate against the dollar. This was in part due to flight to safety in U.S. dollar and, later, due to the brewing eurozone crisis commencing with Greece and spreading to other destinations. Sovereign debt defaults began to loom in the horizon. It was not easy to juggle the currency market amid the entire medley. China’s retreat to the dollar peg was inexplicable. But it adopted the course from the summer of 2008. As Frankel narrates, “In other words, at precisely the moment when the renminbhi changed horses in mid-stream, jumping back on the dollar horse, the dollar horse and the euro horse changed directions.” If the Chinese had held on to the loose basket policy of 2007, instead of switching back to the dollar peg in 2008, the value of the RMB would have been lower and not higher and the dollar based producers would be at more competitive disadvantage. The new dollar peg was forced upon China by the financial crisis. PBoC looked upon it as a temporary measure. We don’t have all the facts and circumstances leading to the decision. On charitable (pro China) view can be that China wished to act as a responsible stakeholder in the global market and did not wish to exacerbate the crisis. It need not have cooperated with the U.S. or G-20 in the global efforts to tide over the crisis. With its huge reserves and ability to operate in the financial market, it could have created more problems for the US/EU. It could have upset currency values by making pronouncements or shifting assets. In the past, it used to hint at “nuclear” threats, i.e. offloading US assets. At the same time, it was aware of the limits to its action and the self-destructive nature of such action. Frankel feels that the Chinese monetary authorities moved back to the dollar “like a security blanket” and “its familiarity in time of crisis trumps the desire to maximize their price competitiveness on world markets.” Another was that they anticipated the dollar to depreciate further. Of course, their desire to protect their dollar assets which run to about 60 per cent of 2.4 trillion dollar could have been the upper most. Overall, their action was responsible and what little progress has been achieved thus far could not have been achieved without their cooperation.

Unfortunately, the U.S. public and Senators do not seem have understood and appreciated these developments. The Yuan rate was again caught up in U.S. domestic politics. The Bush administration with Hank Paulson as Treasury Secretary had reached a better rapport with the Chinese. I had dealt with this in a separate article. (Paulson’s Tango with China, Paper 474 dated 11.4.2010.) On currency and financial reforms they had held repeated discussions and had the assurance of China that it was committed to make the Yuan flexible and market oriented. During the Strategic Economic Dialogue (SED), Paulson did not seek specific commitment on the Yuan. As he said, “The pace of appreciation has increased over the years…I’ve talked to the Chinese enough that we have agreed we don’t talk about how fast is fast.” Unfortunately, Obama administration started off on the wrong foot with the new Treasury Secretary Geithner blaming China for its undervalued currency. This created distrust among the Chinese leaders and it took some months for Geithner to establish proper relations with them. What the later developments were and how both sides met with them would be covered in the next part of this article.

(Part II of the article is to follow.The writer, Mr K.Subramanian, is a former Joint Secretary in the Ministry of Finance, Government of India. He is an associate of the Chennai Centre for China Studies, Chennai,

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