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Tuesday, May 22, 2007

Focus on Yuan "Misplaced and Counterproductive"

Matthew Slaughter, a member of the Council of Economic Advisers from 2005 to 2007, says we should quit focusing on China's exchange rate policy and focus instead on real problems.

Yuan Worries, by Matthew J. Slaughter, Commentary, WSJ:
Fact 1: China runs a large and growing trade surplus with the United States. ... Fact 2: China focuses its monetary policy on fixing the exchange value of its currency, the yuan, relative to the U.S. dollar.

Many policymakers and pundits connect these two facts by asserting that an unfairly low value of the dollar-yuan peg is causing the massive bilateral trade imbalance. ... These misgivings about the dollar-yuan peg are misplaced. Economic theory and data are very clear here on two critical points. Controlling a nominal exchange rate is a form of sovereign monetary policy. And monetary policy, in turn, has no long-run effect on real economic outcomes such as output and trade flows.

Like all other central banks, the People's Bank of China uses its monopoly power over minting its money to control one nominal price. Since 1994 the PBOC has chosen to closely target the dollar-yuan price. In recent times, maintaining this target has required the PBOC to print yuan to buy dollars and thereby accumulate dollar-denominated assets on its balance sheet.

Many central banks today use their sovereign power to fix a nominal short-term interest rate rather than a nominal exchange rate. The U.S. Federal Reserve targets the federal-funds rate; the European Central Bank targets the main refinancing operations rate; and the Bank of Japan targets the overnight call rate. But exchange-rate targets are by no means uncommon..., in 2005, 55.6% of the world's countries fixed their exchange rates. ...

To select a policy target, each central bank must evaluate how alternatives might (or might not) influence its monetary-policy goals. Chinese capital markets today lack many of the microeconomic institutions that transmit changes in short-term interest rates into the broader economy... This may well be one reason the PBOC maintains its exchange-rate target: An interest-rate target might weaken its linkages to the real economy. And just like other central banks, the PBOC has been adjusting its target nominal price gradually, without dramatic changes that can have adverse short-run impacts.

But hasn't the nominal dollar-yuan peg unfairly driven the long-run rise in trade imbalances? No. The exchange rate that matters for trade flows is the real exchange rate... Supply-and-demand pressures in international markets can, and do, alter ... the real exchange rate...

To demonstrate this critical point, look to Europe. The yuan floats against European currencies such as the euro and the pound. If nominal exchange rates were driving trade flows as commonly alleged, then Chinese exports to the U.S. should have been growing faster than to Europe. The data show something completely different... Plotted together over that entire decade, these two series look nearly identical. This is because the same real economic forces -- e.g., China's relative abundance of less-skilled labor -- have been driving both sets of trade flows.

Put it this way: In a counter-factual world where over the past decade China allowed the yuan to float against the dollar, the U.S. would still have run a large and growing trade deficit with China. The real economic forces of comparative advantage that drive trade flows operate regardless of which nominal prices central banks choose to fix.

This week the U.S. government hosts Chinese officials for the second round of the Strategic Economic Dialogue. ... In China, further capital-market reform is needed to support economic growth... Here at home, the large aggregate gains the U.S. has realized from freer trade and investment with China have also generated hardship, too. Many American workers, firms and communities have been hurt, not helped, by Chinese competition.

Issues like these are legitimate and real. But focusing on the dollar-yuan peg is a misplaced and counterproductive way to address them. ... Stop fixating on the fix.

I think this is right. Devoting lots of time, energy, and political capital to China's interest peg policy is not an effective use of our policy resources. Even if we are successful at beating down the peg, not much will be gained and there are other more pressing issues to worry about.

Update: knzn says Aaaargh!!!

Aaaargh!!! (Slaughter on China), by knzn: Why do economists writing about China pretend not to know the difference between sterilized and non-sterilized intervention? We’ve been through this before, but the latest case in point is Matthew Slaughter, writing in the Wall Street Journal (and cited uncritically by Greg Mankiw and Mark Thoma)...

Update: Brad Delong has even more comments critical of Slaughter's analysis. I don't disagree with the critiques, but I don't want to debate this too much because it will make it seem as though this is important for workers.  It's not - it might help a little, but this is not where I'd focus political energy (though Brad is worried about a slightly different issue, the source of imbalances and the potential for growing imbalances to unwind quickly). If the administration is successful and China does amend its currency policy, it may get more credit for helping workers than is due. I still believe (as I said above) that forcing China to change this policy will not do much to help American workers. Here's Paul Krugman on that point:

Fixing Our Economy By Fixing Up Our Workers, by Paul Krugman, Money Talks: ...The pressure from China is greater because of the undervalued yuan. However, even with a big rise in China's currency, wages there would still be only 4 percent of U.S. levels, so currency issues are only a small part of the story.

Update: David Altig says, in conclusion to a longer post analyzing this issue, that:

I may be completely misinterpreting things, but it seems to me that the point is simply that the peg alone cannot be the biggest issue in the discussion.  I guess the disagreement here may be that the Slaughter piece puts more emphasis on the strains that trade-related adjustments in resource allocation inevitably bring, while pgl (and DeLong and knzn, I guess) are more concerned about distortions in resource allocation associated with questionable trade restrictions, capital controls, bad economic policy in the U.S., and so on.  Fair enough. But none of that is about the yuan peg per se, and I think Matthew Slaughter was right to say so.

    Posted by on Tuesday, May 22, 2007 at 12:24 AM in China, Economics, International Finance | Permalink  TrackBack (0)  Comments (31)


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