RIETI Report December 2008

The Appropriate Policy Mix for China

With the holiday shopping season in full swing, those of us who live and work in Japan have probably noticed increased buying power this year, which is an unexpected benefit of the global financial crisis. Since the beginning of the year, the value of the Japanese yen has increased roughly 20% with respect to the U.S. dollar and the euro, and more than 35% when measured against the Australian dollar and the British pound. When we use our yen to purchase foreign-made goods or travel abroad, we are enjoying substantial cost savings and increased purchasing power compared to twelve months ago. The yen's appreciation has been attributed to several factors, one of which being the ability of Japan's financial sector to sidestep the U.S. subprime mortgage-related problems that have dragged down many foreign financial sectors and currencies.

Our neighbors in China, unfortunately, have not been rewarded with a stronger currency despite also avoiding the U.S. subprime-related problems and experiencing strong economic growth. Why? The answer to that question can be found in RIETI Senior Fellow Willem Thorbecke's contribution to this month's RIETI Report: "The Appropriate Policy Mix for China." In his column, Dr. Thorbecke reflects on the optimal foreign exchange policy for China that will balance the country's needs to maintain economic growth, foster domestic consumption, and improve the living standards of its people.

Dr. Thorbecke was also featured in a recent interview article - "The Effect of Exchange Rate Changes on China's Labor-Intensive Manufacturing Exports" - about his latest discussion paper that explores specific sectors affected by exchange rates changes.

This month's featured article

The Appropriate Policy Mix for China

Willem THORBECKESenior Fellow, RIETI

RIETI Senior Fellow Willem Thorbecke is an Associate Professor in the department of economics at George Mason University. He has previously held the position of Visiting Scholar at the ADB Institute, the Jerome Levy Economics Institute, the Social Security Administration, and the Cowles Foundation for Research in Economics. His research has been widely published and his areas of expertise include monetary economics, financial economics, and international economics. Professor Thorbecke received his Ph.D. from the University of California, Berkeley; and his B.A. from Cornell University.

The Appropriate Policy Mix for China


Albert Einstein said that if a zookeeper takes a whip and forces a lion to eat, it will lose its appetite. The U.S. approach to China often resembles the zookeeper's strategy. The United States preaches to China that it should stimulate domestic consumption. U.S. officials also threaten retaliation if the renminbi does not appreciate. The fact that these policies would help the Chinese people is often forgotten in the heat of the debate.

In the past competitive exchange rates and export-led growth have benefited China. They have contributed to rapid growth, lifted millions out of poverty, and raised living standards in urban areas.

Problems facing China

Signs are emerging, however, that resisting currency appreciation is now causing problems for China. Undervalued exchange rates mean that export prices are lower, in turn reducing the wages that Chinese workers can receive. The World Bank recently noted that there is a close correlation between low wages and low levels of consumption in China. If workers' wages increase, they would be able to consume more. In addition, to keep its exchange rate weak without stoking inflation, China has had to accumulate trillions of dollars of low-yielding U.S. securities and other foreign assets. By investing in these assets China is misallocating its scarce resources. Private and social returns would surely be higher from investing in education and healthcare in the rural sector, cleaning up the environment, and making cities more livable.

In order to re-channel funds out of foreign assets and into domestic investments, the Chinese would have to let their exchange rate appreciate. This would reduce China's exports of toys, textiles, and other low technology goods. However, it would allow Chinese companies to purchase more sophisticated capital goods from abroad. Also, research has shown that technology transfer from multinational companies to developing countries increases as the workforce in the host country becomes more educated. If China withdraws foreign exchange reserves from U.S. securities and invests in education in China, it will help Chinese companies to assimilate new technologies and move up the value chain.

An appreciation of the RMB would also help shift production from tradable goods to services. Chinese output would then be directed to Chinese consumers, allowing domestic markets rather than exports to drive job creation. This approach would both reduce Asia's exposure to the slowdown in the rest of the world and allow domestic consumers to enjoy the fruits of their own labor.

This approach would also give firms in other countries a greater incentive to focus on meeting the needs of Chinese people. Companies in developed countries have developed sophisticated goods that China could use to provide healthcare, fight environmental degradation, and meet other key priorities. There would thus be opportunities for mutually beneficial exchanges between foreign companies and China.

Renminbi appreciation methodology

What would an exchange rate appreciation in China look like? First China could abandon its de facto dollar peg and adopt a regime characterized by a multiple-currency, basket-based reference rate. The advantage of a multiple-currency, basket-based reference rate is that it would lessen exchange rate volatility between China and its trading partners. The current de facto dollar peg has produced unprecedented exchange rate volatility between China and its largest export market (Europe). The RMB depreciated 45% against the euro between March 2002 - March 2008, and appreciated 25% against the euro since then. China could smooth out these fluctuations by pegging the RMB to a basket of currencies including the euro and other important currencies.

Second, China could adopt a wider band around the central parity. If China adopted greater exchange rate flexibility in this way, its large surpluses with Europe and the U.S. would cause the renminbi to appreciate against the euro and the dollar and reduce China's imbalances.

If the RMB did appreciate against the dollar, other currencies in Asia would also automatically appreciate against the dollar. This would occur because other Asian countries such as Singapore and Malaysia attach large weights to the RMB in their currency baskets. Thus Asian exchange rates would tend to appreciate together against the dollar while remaining somewhat stable within the region.

Such an appreciation in Asia would offset the deflationary forces that are threatening to engulf the U.S. If Asian currencies did not appreciate and the U.S. instead experienced deflation, the current Asian export slowdown would become a standstill.

Recommended policy measures

So a good policy mix for China would be an appreciation of its currency combined with a strategy of focusing on the needs of the Chinese people. For China to succeed at this strategy, it must ensure that the forthcoming fiscal stimulus supports activities that benefit people (e.g., educating the rural poor or providing healthcare) rather than activities that enrich corrupt officials (e.g., erecting opulent buildings or constructing unneeded highways).

China has stood up to the U.S. at the latest Strategic Economic Dialogue in Beijing. The Chinese leaders have recently decided, though, that apart from U.S. pressure it is in China's own interest to reject currency depreciation and to stimulate domestic demand. These are wise and responsible actions. In the long run, China should continue to allow its currency to appreciate as part of a strategy of climbing the ladder of comparative advantage and focusing on the welfare of domestic citizens.

The emergence of a more prosperous China with a more flexible exchange rate would not only raise living standards in China, but also provide a robust engine of growth for the rest of the world. Over time this could help the world economy escape from the crisis now gripping it.

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