Protect-yuan-ism

Independent economist explains why Beijing''s recent yuan revaluation will not halt trade protectionism.

In terms of global economic influence, the biggest failure of the recent yuan policy shift by Beijing is its inability to halt trade protectionism which, in my view, is the biggest risk facing Asia and the global economy in the coming years. Nevertheless, the small yuan revaluation will bring some short-term benefits to Asia's markets.

The yuan's 2.05% revaluation against the US dollar aside, Beijing's shift to a managed float for the yuan pegged to a currency basket amounts to a crawling yuan appreciation under the current balance of payments forces. The conventional wisdom is that while the yuan policy shift is small, it is the start of a series of further yuan revaluation that will re-align other East Asian currencies by pushing them up against the US dollar. This will help correct the global, especially US, trade imbalances, the logic goes.

The myopic protectionists

Those protectionists who have been pushing for a large yuan revaluation to correct the US current account deficit are not happy with the yuan's small moves. They will push the Bush Administration for more pressure on China to revalue the yuan further in a belief that a large yuan revaluation could correct the huge US external deficit.

But they are dead wrong in arguing that. They are in denial about structural problems in the US. They are also naïve in believing that revaluing the yuan alone can help solve the deficit problem and bring jobs back to America. They have ignored the spendthrift habits of the Americans, as evidenced in US import elasticity with respect to domestic economic growth.

Put simply, this elasticity is a ratio of the percentage change in imports to the percentage change in economic growth. It reveals how much imports rise/fall when income growth rises/falls by one percentage point.

For a long time, America has had far higher import elasticity than other economies. This means the US has been importing a larger amount of goods and services for every percentage point of US growth than its trading partners' growth sucking in US exports.

In other words, the US has been selling less export to its trading partners for every percentage point of their growth than they have been selling to the US.

When economists first found this empirical evidence in the late 1960s, they could not explain the Americans' spendthrift behaviour and thus wrote it off as some sort of a glitch that would disappear after some years. But it has not gone away.

It is true that the US has grown faster than major trading partners, like Japan, Germany and France, in recent years so that the US has also imported more than these trading partners. But the entrenchment of this import elasticity differential means that even if US growth were to slow to the same rate as its major and slower-growth trading partners, America's current account deficit would still worsen.

So in addition to slowing US economic growth, there is a need for relative price adjustments, via exchange rate movements, to assist the process of paring the huge US external deficit. The protectionists have jumped on China in pushing this logic for large yuan revaluation, while denying the US extravagance problem.

Yuan revaluation won't help

They are going to be disappointed because even a large yuan revaluation (25% to 30%) will not change the US current account deficit much. First, as long as there is economic growth in America, the country's import addiction will remain, as evident in the high import elasticity. A sharp economic recession will correct the deficit by crushing import demand, but that is not an acceptable option for the politicians.

Second, according to US customs data, America's imports from China (including those from the Mainland and Hong Kong) account for an average of only 11.2% of its annual total imports since 1999. This simply means that revaluing the yuan will have very limited impact on cutting the US overall trade deficit.

The US dollar has fallen by an average of over 10% against the Euro, Yen, British Pound and the Canadian dollar since 2003. The host countries of these currencies are far larger trading partners with the US than China; and there has been no improvement in the US trade deficit (even allowing for the J-curve effect). If the appreciation of their currencies had no impact on the US external deficit, why would one expect the yuan to be different?

The unfortunate result of all this is that the protectionists will continue to deny the US domestic demand problem and keep pushing for more yuan revaluation blindly by threatening China, and the world, with more protectionist measures. And protectionism is going to intensify as the structural changes in global manufacturing continue.

It is also unfortunate that the US has gone back on free trade after years of efforts on promoting globalisation. Given its powerful leadership role in the global economy, America's protectionist attitude could set a bad example for the rest of the world to follow.

Medium-term risk - a dollar crisis

While this is a longer-term threat facing Asia, there is potentially another tangible risk in the medium-term. The yuan policy shift to a managed float against a currency basket has raised the concern about Asia withdrawing support for the US dollar, by reducing its huge demand for US financial assets. This brings us back to the fundamental issue of the need for relative price changes, via exchange rate adjustments, to cure the US current account deficit.

Given the huge size of the US current account deficit, any attempt to adjust it by solely slowing US growth would inflict huge damages on both the US and global demand. That would risk a global economic implosion, and thus will not be an acceptable solution to anyone.

Further, the import elasticity differential between the US and its trading partners means that it is implausible to cut the US current account deficit by only slowing US growth. Thus, in addition to demand management, the US dollar exchange rate needs to fall, while those of its trading partners need to rise further to help the US adjustment process. But with doubtful Asian support for the US dollar, the currency adjustment may cause significant financial volatility, such as a US dollar crisis, along the way.

In a nutshell, the recent yuan shift may be an omen for significant global demand and policy shifts, with a complicated and uncertain impact on the global economy. What is sure is that the world is going to live with more protectionism and trade friction in the coming years. And if the US continues to deny its harmful consumption behaviour, the consequences seem clear.

Short-term benefits

For the US, the RMB adjustment, though small, is a sign of victory for the Bush rhetoric, as China has moved with both a revaluation and a shift to a currency-basket peg. The managed float against a basket of currencies means that China will use the basket as a guide for intervention. Hence, the RMB could move more flexibly against the USD than the 2% revaluation implies.

For China, the shift to a currency-basket peg will increase its monetary flexibility in managing the economy. The small revaluation signals that it was not a result of US pressure, which pushed for much bigger revaluation.

The revaluation also came with no economic pressures - China's current account and foreign reserves are still healthy, inflation remains tamed, and economic growth remains robust while the speculative bubbles are being diffused. Meanwhile, the US dollar has risen recently so that there would not be major speculative capital inflows to China following an RMB revaluation. All this means that the RMB revaluation should cause minimal disruption to the markets.

From a market perspective, the combination of the small revaluation and the shift to currency-basket pegging signals that more reforms are coming and that the Chinese are flexible to implement them. This will increase international confidence in China, and hence is conducive to more long-term capital inflows to both China and Asia, and hence demand for the region's assets.

Meanwhile, the small revaluation will sustain the expectation that more small-step RMB revaluations may come. This will sustain capital inflow, though of short-term nature, to Asia, notably to HK, Taiwan and Malaysia whose currencies are either strictly or loosely peg against the US dollar.

All this will boost Asia's liquidity, helping to offset some of the risks stemming from rising interest rates, high oil prices and a potential US economic shock that Asian markets are facing.

Chi Lo is an Economic Strategist based in Hong Kong and author of "The Misunderstood China", Pearson Prentice Hall 2004