China in Transition

Is a Weak Yuan Really to Blame for China's Progress and Japan's Decline?

Chi Hung KWAN Consulting Fellow, RIETI

In recent years, we have come to see comments frequently made by the media seeking to place the blame for China's advance and Japan's decline on a weak yuan. For example, in his column that appeared in the July 11 edition of the Nihon Keizai Shimbun, professor Yoshiyasu Ono of Osaka University presented this view as though it were only natural. It is one thing for such an opinion to be voiced by an amateur, but I cannot believe that a famous economist can put forth such a naive argument.

In his column, Ono maintains that "the price competitiveness of Chinese firms is more the result of changes in the yuan's exchange rate rather than corporate effort." It is true that in the 25 years since China began adopting market-opening reforms, the yuan has fallen sharply against the dollar both in nominal terms and in real terms that reflect the inflation gap between China and the rest of the world. However, plenty of other developing countries have also depreciated their currencies - why is it only the Chinese economy that is growing so fast? If an economy could take off simply by depreciating the currency, then the hundred-plus developing nations in the world today would easily become industrialized nations and the North-South problem would be solved in a single stroke. In such a utopia, there would be no reason for the World Bank or official development assistance to exist. However, as economists should know best, there is no such thing as a free lunch.

As economics textbooks say, short-term economic trends are determined by demand-side factors, while long-term growth and development are determined by supply-side factors. Although currency fluctuations, like monetary and fiscal policies, affect the economy mainly through demand, the fundamental reason why the Chinese economy achieved a high growth rate averaging 9 percent for a quarter of a century should be sought from the supply side. In accordance with growth accounting, China's growth has been brought about by an increase in the input of factors of production, such as labor and capital, and a rise in productivity. Furthermore, it must be understood that this has been supported through institutional reforms that moved China from self-reliance to market-opening and from a planned economy to a market economy.

Professor Ono not only argues that China's progress was made possible through a weak yuan - he also blames the poor performance of the Japanese economy on "unfair" competition from China. In his column, he declares that, "The argument in Japan and the United States, that China is a threat, is simply the result of policy brought about by the artificial weakening of the yuan." However, even if a currency's depreciation will in the short-term support the economy by boosting external demand, domestic prices will gradually rise with time, and in the long-term the real exchange rate should return to a state of equilibrium. As this shows, a currency's real exchange rate over the long-term is not a policy variable that can be artificially decided by a government, but an endogenous variable that reflects economic fundamentals. In China's case, the yuan's weakening over the long-term, reflects the decline in the terms of trade (the relative price of export goods against import goods) due to the rapid increase in exports.

It must also be said that the perception that a weak yuan negatively affects the Japanese economy is based on the tacit presupposition that China and Japan have similar industrial structures and have a fierce competitive relationship in international markets. However, there is in fact a clear division of labor in line with the comparative advantages of the two nations - China specializes in labor-intensive goods and processes, while Japan handles technology-intensive goods. Therefore, it is clear that the two countries are in a complementary, rather than competitive, relationship. This being the case, the fall in the price of imports from China, just like a decline in oil prices, improves Japan's terms of trade and should boost the welfare of the Japanese economy as a whole. As this proves, the idea that, "The reason why Japan cannot come out of recession is because of high costs, and if the current situation is left unaddressed, the country will lose to China and exports will fall, further dampening the economy and bringing more ruin onto Japan," is nothing but paranoia.

Ono drew the wrong conclusion because he misapplied the Keynesian model, which is only valid in analyzing short-term economic trends, to explain the issue of long-term economic growth and development. Many economists, not just professor Ono, wrongly believe that building abstract models, rather than conducting positive analysis, is what "economics" is really all about. I think they should get out of their ivory towers and go back to basics, striving to inquire into the nature and causes of the weatlth of nations based on the spirit of "seeking truth from facts."

July 18, 2003
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July 18, 2003