China’s Currency Manipulation: Better Look Twice
The world will be watching when Donald Trump’s presidency begins in 2017. And although his inauguration is yet to come, president-elect Donald Trump, primarily by using his Twitter account, already comments on current issues and developments. Early in December, he sent out a series of tweets, in which he accused China of impeding US exports and threatening US manufacturing jobs by deliberately manipulating its currency. We asked Rolf J. Langhammer about whether Trump was right or not and what the reason behind the depreciation of the yuan is.
Rolf J. Langhammer is a Professor of economics, former Vice President of the Kiel Institute for World Economy and expert on China’s economy. An opinion piece by the author on the same topic was first published on the Mercator Institute for China Studies’ blog “European Voices on China”.
GESblog: Prof. Langhammer, could you clarify in 140 characters – Twitter-like – if President-Elect Trump is right with his accusation that China’s currency interventions hurt US exports and jobs?
Rolf J. Langhammer: Oh, this is fairly easy: “Nothing could be further from the truth. #betterlooktwice”. The explanation to this, however, needs some more characters.
GESblog: But it is correct that China manipulates its currency. In this case, Donald Trump is right.
Rolf J. Langhammer: The depreciation of the yuan is a fact, yes. Yet, by accusing China of having an intentionally undervalued currency, Trump barks at the wrong tree. It’s just the opposite. Chinese authorities prop up the yuan in the face of external depreciation pressures rather than devaluing their currency to protect their export industry. As a matter of fact, this is more likely to help than to harm the American worker.
GESblog: What has led to this weakness of the yuan?
Rolf J. Langhammer: The current situation is due to market developments in both China and the US. It’s not “handmade” by government policies to suppress domestic demand or to weaken the yuan by selling it against dollars. Chinese households and companies have jumped to new opportunities to use local currency for non-Chinese asset purchases (in particular for FDI), especially because of perceived higher profit margins abroad. This is understandable in the light of declining average and marginal productivity of capital as China transitions into a new stage of lower growth, which is inward-oriented, innovation-driven and focused on high quality services production.
GESblog: What was the US development that contributed to the yuan’s weakness?
Rolf J. Langhammer: It is closely connected to Trump’s promise to fuel the domestic economy through a massive fiscal expansion program, which promises job creation in the short run regardless of its medium or long-term financial sustainability. In addition to both continued increases in the Federal funds rate and doubts on a sustained recovery of European economies, the announcement of this domestic program leads to a stronger dollar and causes the Chinese Central Bank to reassess its currency basket exchange rate targeting, which is centered around the US dollar.
GESblog: What were the actions taken by the Chinese authorities to control this situation?
Rolf J. Langhammer: The Chinese authorities had two options: Raising domestic interest rates to prop up the yuan or restricting capital exports as the seemingly less costly measure. They chose the second option. Without controls and without abandoning exchange rate targeting, higher domestic interest rates would have been the only effective tool against capital outflows. But deploying it would have come at the cost of an unwelcome slump of domestic demand and of GDP growth in China.
Capital export controls on the other hand allow the government to steer foreign investment into areas that align with China’s industrial policy targets of technological upgrading (“Made in China 2025”) and to discourage or prevent private business investment with the sole goal of profit making and asset spreading, such as investment in international hotel chains.
GESblog: This sounds a lot like government is a better strategic investor than businesses.
Rolf J. Langhammer: Indeed, this is the assumption on which this strategy is based, but it’s a doubtful assumption. Yet, If capital controls are not enough to stem the yuan’s decline, China’s Central Bank could intervene in foreign exchange markets by selling dollars – as it has done since mid-2015 when unexpected changes in its exchange rate regime plus volatilities in Chinese stock markets caused disturbances in international financial markets and pressure on the yuan.
GESblog: You said that Trump’s allegations were wrong and that the current situation would rather help than harm the US workers. What could this monetary policy do to China?
Rolf J. Langhammer: Firstly, it is a matter of profit. If Chinese capital must stay within the country and cannot be invested in sectors that are profitable under conditions of open capital accounts, there is a danger it could be wasted in domestic sectors. That’s probably not such much of a problem if you have a lot of capital at hand, but capital is no longer as abundant as it used to be in China. So such resource misallocation can impede the ambitious “Made in China 2025” targets.
Secondly, strict capital export controls could carry high political costs for China. Chinese authorities risk a confrontation with foreign investors in China, who see legal ways of repatriation of their profits endangered. They could try to repatriate profits by using so-called “transfer pricing” strategies of under-invoiced their exports and/or over-invoiced their imports if normal channels of profit repatriation are narrowed or even closed. Many of these investors come from the U.S. and could lodge official complaints with the new US government if profit repatriation should be severely hindered.
GESblog: Controls that are too tight often lead to informal ways of getting things done. Is that a likely scenario as well?
Rolf J. Langhammer: Quite likely, there will be the temptation of domestic investors to use such informal channels to export domestic currency and buy assets abroad. The yuan’s gradual internationalization helps Chinese capital owners to shift money abroad. The higher the financial rewards from bypassing controls, the more resources would be spent by the private sector to export capital and the more resources the Chinese authorities would have to deploy to fence it in.
GESblog: A while ago we talked about the yuan as a new “freely usable currency”. How will these strict controls of capital export affect this status of the yuan?
Rolf J. Langhammer: This policy could certainly affect the yuan’s international status. The International Monetary Fund could reassess its positive judgement as “freely usable currency”. Furthermore, it could weaken incentives for the world’s leading Central Banks to hold greater shares of their reserves in yuan.
GESblog: What is your take on how China’s current policy and Trump claims to protect the US economy will work out?
Rolf J. Langhammer: There is no doubt that Chinese authorities have embarked on a risky path by building a fence around their currency. The introduction of stricter capital export controls in China violates the spirit of a globalized economy as much as Trump’s protectionist policy announcements would if they were implemented. With China shutting off its financial markets and the U.S. closing off its markets for the trade of goods, the global economy is truly in the doldrums.