China Tells

During President Obama’s visit to Beijing, one of top priority topics that he discussed with President Hu Jingtao is the exchange rate of RMB. Due to the fact that RMB is pegged to USD, so claims Obama, it is artificially under valued and does not reflect the true Purchasing Power Parity. Such an under valuation is one of the major causes for a global imbalance: China accumulates huge surplus and USA accumulates huge deficit. In fact, according to the latest figure from National Bureau of Statistics, China’s trade surplus reached 24 Billion USD in October 09, which is a fifth month of consecutive increase y-o-y in its trade surplus (See Graph below). Therefore, to address such an imbalance, so goes the logic, China government need to revalue RMB or loosen the peg.

The counter argument from China government, however, is that how can US government demand China government to revalue its currency while they themselves are letting the USD slide in a free fall? It seems very unfair that US government is applying a double standard to its own currency and someone else’s currency. As a matter of fact, USD has lost about 15% since the beginning of the year against world’s major currency. Therefore to maintain the world trade balance and stability, US government shall preserve the value of USD first before pointing the finger to Beijing.

Such a counter argument seems reasonable on its face. In fact, it is what China government has been practicing: to maintain an independent exchange policy through a soft peg to USD regardless the external pressures. However, there are a few caveats in pursuing such a policy.

First, it upsets the other trading partners such as EU and Japan. By maintaining the peg, RMB has de factor depreciated against other major currencies such as JPY and EUR thanks to the depreciation of USD. Whatever the reason, it does give China export sector a material benefit with its product more competitive internationally. The net result is that it comes with a cost to other exporters such as Germany, Canada and Japan. In fact, China has surpassed Germany as world’s top exporter and also surpassed Canada as the biggest exporter to US in 2009. Such a status change has aroused pressure to revalue RMB not only from US, but also from other trading partners such as Canada and Brazil, who normally are close allies with China on multiple fronts. So far it seems that China government has a way to navigate around the pressure from US on the RMB rate, but can China government keep the rest pleased at the same time? Or is it worth for China government to run the risk of upsetting the other trading partners at an unnecessary cost? A more neutralized way seems to peg RMB to a basket of major currencies instead of a weakest one (USD) so that it reflects the fair value in a more accurate sense.

Second, assume that China government is capable of fending off all the criticism and pressure, and successfully continues a forex policy with total freedom and independence. Given the globalization age that we are in today, it is not necessarily in the best interest of China economy. China has about 1 Trillion USD of its foreign reserve invested in US Treasury so the value of such holdings are largely relying on the mercy of US government who literally sets the value of the currency. In addition, US have other ways to pressurize the rate of RMB besides verbal persuasion. For example, because of the value loss in USD, the international commodity price (ie, oil) denominated in USD reacts with strong rebounds. A high oil price is bound to increase the cost of production in China as it imports about 50% of its oil need from the international market. In combination to China’s domestic loose monetary policy, there is a huge risk for China to face inflation problem in the near future, like what happened in first half 2008, when China’s inflation exceeded 8%. By then, China government probably will have no choice but to increase the interest rate and adjust the exchange rate, which could hurt its export sector and economic growth to a large extent.

To summarize, China government’s current foreign exchange policy probably need to be reviewed carefully. It is a great challenge to protect the export sector, keep the workers employed and also not to upset the trading partners and achieve a win-win result. Such a review shall also encourage free trade in a difficult time and benefit all the countries over the world.