In the last year or so, many analysts, including the International Monetary Fund, have argued that China's currency is now properly valued and the country is no longer deliberately holding down the yuan in order to maintain its trade surplus. This view may be politically convenient for many, but it is wrong. While the currency is not nearly as under-valued as it had been at the start of the decade, it is still below where it would be in the absence of the intervention of China's government. As a result, we have the extraordinary situation in which one of the fastest growing countries of the world is exporting capital to slow growing rich countries. This does not make sense and it remains a major source of imbalances throughout the world economy.
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The Econ 101 story of trade and investment flows is that capital is supposed to flow from slow-growing rich countries, where it is relatively plentiful and therefore gets a low rate of return, to fast growing developing countries where capital is relatively scarce. In principle capital will get a higher return in the developing world, so in the absence of government intervention, we would expect this flow from rich countries to poor countries.
The mirror of capital flowing to the developing countries is that the rich countries run trade surpluses and the developing countries run trade deficits. The trade deficit allows developing countries to provide essential consumption goods to their populations even as they divert large amounts of resources to building up their infrastructure and private capital stock.
As a practical matter, flows of world trade have not matched this story closely. While there have been times where capital did flow from rich countries to poor countries, for example in the 1990s until the East Asian financial crisis in 1997, there have also been long periods where the flows went in the other direction. However the outflow of capital from the developing world, and China in particular, has never been as large relative to the size of the world economy as has been the case in this century.
This outflow of capital, and the trade deficit it has created for rich countries and especially the United States, has led to an enormous gap in demand. For some reason, even the economists who worry about “secular stagnation,” a prolonged gap in aggregate demand in the economy, don't like to talk about the trade deficit. They are anxious to push for larger government deficits or other measures that may spur demand, but taking steps to reduce the trade deficit is largely off the agenda.
This must be explained by non-economic concerns, since a reduction of the trade deficit equal to 1.0 percent of GDP has the same impact in boosting demand as a boost to infrastructure spending of 1.0 percentage point of GDP. Even if the latter might be more desirable because of its long-term effect in boosting productivity, in a world where politics strictly limits budget deficits, it is hard to see why economists would not look to lower trade deficits as a mechanism for increasing demand.
The key route to reducing the trade deficit is a lower value of the dollar relative to other currencies. China plays the key role here, since it is the country with which the United States has the largest deficit. It is also important since many other developing countries are likely to follow China as a competitor. This means that if China raises the value of its currency, countries like Thailand, Vietnam, and Cambodia will do the same, thereby amplifying its effect.
In the last couple of years analysts have pointed to the fact that China is no longer buying large amounts of dollars to keep down the value of its currency. In fact, at several points in the last year it has sold substantial amounts of reserves in order to keep the yuan from falling. However this does not mean that the actions of China's central bank are not keeping the value of the yuan below its market level.
China's central bank still holds more than $3 trillion in reserves, an amount that exceeds 30 percent of its GDP. This dwarfs the amount that would ordinarily be deemed sufficient for a country like China. In fact, a recent analysis by the I.M.F. put China's reserve holdings at more than twice the level needed for normal precautionary purposes.
This matters in assessing currency values, since it is not only the flows that matter but also the stocks. Almost all economists would agree that the Fed's holdings of more than $3 trillion of assets are helping to keep down long-term interest rates. By the same logic, the decision by China's central bank to hold a far larger amount of reserves than necessary is helping to keep up the value of the dollar relative to the yuan.
China is clearly going through a difficult transition at the moment and no one could expect it to abruptly dump reserves to raise the value of its currency. However this should be a top priority for the United States in its negotiations with China. The goal should be a clear path towards a higher yuan and a movement toward more balanced trade. As negotiations work, this would mean the United States would have to make concessions in other areas. For example, it can relax demands on enforcement of U.S. copyrights and patents and also market access for our financial industry, but other concessions may be appropriate as well.
This is not a question of China bashing; this is a case where the United States would be pushing the country in the direction to which it has already committed itself. China's leadership recognizes that its future growth must depend more on domestic consumption, which also implies further improvements in living standards for China's population.
Imagine how much better off China would be today if a decade ago the United States had made raising the value of the yuan its top priority in negotiations and pushed other issues to the sidelines? We would still be doing both China and the world economy a favor by going down this route.
