|HONG KONG – At the recently concluded World Economic Forum Annual Meeting in
Davos, Switzerland, Chinese President Xi Jinping mounted a robust defense of
globalization, reaffirming his country’s “open door” policy and pledging never to seek
to start a trade war or to benefit from devaluation of its currency. Soon after, US
President Donald Trump, in his inaugural address, effectively made the opposite
pledge: using the word “protect” seven times, he confirmed that his “America first”
doctrine means protectionism.
Trump speaks of the United States as an economy in decline that must be revitalized.
But the reality is that the US economy has been performing rather well in the last two
years. Its recovery has outpaced that of other advanced economies; job creation has
been impressive; and the dollar has been strong.
The dollar’s value has risen particularly high in the last few months, as Trump’s
promises to increase government spending, lower business taxes, and cut regulation
have inspired a flight to quality by investors. By contrast, the Chinese renminbi has
weakened significantly – from CN¥6.2 per dollar at the end of 2014 to CN¥6.95 at the
end of last year – owing largely to declining investment and exports.
Trump has accused China of intentionally devaluing the renminbi, in order to boost its
export competitiveness. But the truth is quite the opposite: in the face of strong
downward pressure on the renminbi, China has sought to keep the renminbi-dollar
exchange rate relatively stable, – an effort that has contributed to a decline of more
than $1 trillion in official foreign-currency reserves.
China does not want the renminbi to depreciate any more than Trump does. But no
country has full control over its exchange rate. From technological developments to
geopolitical rivalries to policy shifts among major trading partners, the causes of the
renminbi’s decline – and, thus, the factors influencing China’s exchange-rate policy –
are varied and complex.
One factor affecting exchange rates is a rapidly changing global supply chain.
Evolving consumption patterns, regulatory regimes, and digital technologies have
lately encouraged more domestic production. In the US, manufacturing has received
a boost from technologies like robotics and 3D printing. That has supported economic
recovery, without increasing its imports from Asia.
Meanwhile, China is already shifting from an export-driven growth model to one
based on higher domestic consumption, so a stronger renminbi might serve its
economy better. China’s current-account surplus fell to just 2.1% of GDP in 2016,
and the International Monetary Fund projects it to narrow further, as exports continue
But the current account is not the only relevant factor. Given the role of capital flows
in exchange rates, BIS economist Claudio Borio argues for looking at the financial
account as well. Here, too, a depreciating renminbi doesn’t serve China.
According to the IMF, by 2021, the US net investment position will probably
deteriorate – with net liabilities rising from of 41% of GDP to 63% – while China’s net
investment position remains flat. This means that other surplus countries like
Germany and Japan are likely to be financing the growing US deficit position, from
both their current and financial accounts. (The expanding interest-rate differentials
between the US and its advanced-country counterparts reinforce this expectation.)
But perhaps the biggest challenge for China today lies in its capital account. Since
the renminbi began its downward slide in 2015, the incentive to reduce foreign debts
and increase overseas assets has intensified.
China’s total foreign debts (public and private), already very low by international
standards, have fallen from 9.4% of GDP ($975.2 billion) at the end of 2014 to 6.4%
of GDP ($701.0 billion) by the end of last year. And this trend seems set to continue,
as Chinese citizens continue to diversify their asset portfolios to suit their increasingly
international lifestyles. A weaker renminbi will only bolster this trend.
Of course, Trump, who has repeatedly threatened to impose tariffs on China, could
also influence China’s exchange-rate policy. But, in a sense, Trump’s irreverence
makes him practically irrelevant. After all, judging by his past behavior, it seems likely
that he will accuse China of currency manipulation, regardless of the policy path it
chooses: a completely free float with full convertibility, the current managed float, or a
pegged exchange rate.
So what is China’s best option? A free-floating exchange rate can be ruled out right
away. In the current dollar-driven international monetary regime, such an approach
would produce too much volatility.
But even the current regime is becoming difficult to manage. Considering the cost of
recent efforts to maintain some semblance of exchange-rate stability, it seems that
not even the equivalent of $3 trillion in foreign-exchange reserves is enough to
manage a currency float.
To be sure, China can – and should – broaden and deepen its international
investment position, in order to support currency stability. At the end of 2015, China’s
gross foreign assets were relatively low, at 57.2% of GDP, compared to about 180%
for Japan and many European countries and around 130% for the US. Meanwhile,
China’s net foreign assets amounted to only 14.7% of GDP, compared to 67.5% for
Japan and 48.3% for Germany (negative 41% of GDP for the US). Reforms in the
real and financial sectors would enable this level to rise.
For now, however, the best option may be for China to peg the renminbi to the dollar,
with an adjustment band of 5%, within which the central bank would intervene only
lightly, to guide the market back to parity over the long term. Investors are, after all,
focused almost exclusively on the renminbi-dollar exchange rate.
Whatever path it chooses, China will pay a heavy price for advocating globalization
and pursuing currency stability. In a world in which announcing new policies – and
thus moving markets –is as easy as sending a tweet, politics will trump rational
This article first appeared in Project Syndicate, 27 January 2017