Unless you can:
a) magically rid international commodity fluctuations with the dollar
b) rid the world of its dependence on the dollar
c) diversify your forex holdings rapidly, to the extent that it is primarily non-dollar bullion or another commodity or currency
d) manipulate exchange rate valuations, export competitiveness - domestic and international, domestic liquidity, institutional investment flows, energy demand (rapidly diversify away from oil, so that coal or nuclear or wind energy is your primary source of economic propulsion)
you cannot and will not make more than marginal appreciations in the value of the
yuan.
Because, China's currency is unofficially pegged to the dollar, and China has such vast holdings of dollar-bound (treasury bills) forex reserves, and because China is so dependent on oil, and will remain so for the foreseeable future, a significant appreciation of the yuan, and a subsequent devaluation of the dollar will impact China far greater than you tend to imagine.
You may revalue the yuan
retrospectively, which will lead to nothing other than a retrospective inflation of nominal GDP, not to anything significant or tangible.
Marginal revaluations, as I've said, also leads investors to speculate on further appreciation, causing hot-money inflows to swell domestic liquidity.
China has not had to deal with this yet, but a previous tackling of the problem in Korea have shown that the "excess liquidity trap" is a burden. Some of the measures to discourage inflows have taken the form of making previous measures to discourage outflows more symmetric, while others have taken the form of reinstating much reduced or eliminated restrictions. These limits on capital inflows can be quite effective, but they set back the development of financial markets, reduce the rate of employment growth (eventually lead to un-employment) and clash with ambitions for internationalized currencies in the region.
The excess liquidity trap also has three dimensions:
- China is concerned that excess domestic liquidity will cause economic overheating, but it is afraid to raise interest rates and tighten monetary policy more aggressively for fear that it would slow employment growth, generate additional non-performing loans in the banking system and attract additional liquidity from abroad.
- China cannot continue to sterilize large amounts of excess liquidity in the banking system indefinitely without risking a qualitative deterioration of the balance sheet of the central bank, the People's Bank of China (PBoC), a decline in the profitability of banks (if reserve requirements are raised too high) or other monetary problems.
- It is difficult to protect the value of China's huge foreign exchange reserves against US dollar decline precisely because the reserves are so huge and because the dollar's share in those reserves is so large and is projected to remain so.
2008 saw the increase in China's consumer price index (CPI) reach a worrying 8% year-on-year. For most of the period between 1998 and the early 2007's, China's CPI was low or negative. Unlike inflation of the early 90's, which was then fueled by an overheated economy (rapid domestic demand growth fueled by excessive credit expansion), the recent inflation cycle was mainly ignited by incidental domestic supply-side factors in the food sector (mainly pigs and poultry), reinforced by a sharp global price increase for imported oil, coal, soybeans and other grains and metals. The combined effect was to drive up the inflationary price of many food items (especially pork, poultry, eggs, vegetable oil and dairy products).
CPI inflation received an extra jolt in the early months of 2008 as a result of an unusually severe winter storms that disrupted transportation and power supplies in the country's south. The non-food CPI remained surprisingly modest and stable , but the producer price index (PPI) - a contributor to CPI inflation in the longer term - rose sharply in those months, to 8.2% in May.
Unless China is willing to brace massive turbulent social unrest, in the form of spiralling inflation and capital outflows leading to decreased liquidity and employment, a substantial nominal revaluation of the yuan is unlikely. Do I need to tell you of the linkages between exchange rates, purchasing power parity, inflation and interest rates? Or that a lower nominal exchange rate (an increase in the valuation of the yuan) necessitates a decrease in the interest rates, offshoring foreign investments to other more lucrative destinations (as the rate of return on capital falls), leading to a glut in money supply (as the rate of borrowing decreases), and by the relationship between money and prices, lead to a higher (spiralling) rate of inflation.
As long as the chinese central bank keeps interest rates artificially high, to encourage foreign institutional investors via the rate of return on capital, and all other factors apply, a revaluation of the yuan (affecting nominal exchange rates and the
nominal value of the currency) is not likely.
Additionally, the increase in GDP growth from 10.1% in 2004 to 11.9% in 2007 was
almost entirely due to increases in net external demand, not domestic demand. Monetary expansion in 2007 was moderate; it was not a primary cause of either CPI or PPI inflation. A revaluation of the yuan would shift economic growth dependency to domestic consumption, rather than external demand- a factor that is concomitant with significant erosion in the growth rates given that China is the world's 'factory'.
Those advocates, such as you, who are touting a revaluation of the RMB by 15% or 40% are really asking China to adjust upwards its domestic price level by 15% or 40%. But why not just recommend to Chinese policy-makers 15% or 40% inflation? We can see immediately the difficulties in engineering inflation as high as 15% to 40% in China. Structural inflation, which accommodates domestic price level changes, works through individual markets with much less shocks to society than sudden and large exchange rate changes. On the other hand,
monetarily-induced inflation, carries the risk of decreased export competitiveness, large societal upheavals, eroded savings and fiscal contraction.
You're smokin' a pipe dream! In dollar terms, the US's industrial output As of Dec. 31, 2009, US industrial output is $2.7 trillion and is more than China AND Japan combined. Consider this in llight of the fact that US is coming off its worst industrial recession since WWII, has registered stellar economic growth in core sectors in the last quarter of 2009: my november figures indicate construction activity rose 1.6%, materials rose 1.3%, non-industrial supplies increased 1.0%, business equipment rose 0.4%, final products rose 0.4%, and consumer products increased 0.3%; By group, mining activity increased 2.1% and manufacturing rose 1.1%; however, utilities sector activity fell 1.8%; and is operating at 99.4 percent of its 2002 average.
Industrial Production and Capacity Utilization
As to the second part of your argument, which is:
Unfortunately, in the forum of public policy debate, rates, especially nominal rates are thought to be the most important factors affecting trade imbalances and competitiveness, which is a misunderstanding in both theory and practice. The implication is that as long as China maintains free trade, China’s nominal exchange rate will always be consistent with the PPP exchange rate based on tradable goods because of the possibility of market arbitrage. But that is nonsensical because they are not based on a PPP exchange rate derived from buying a bundle of goods that also includes non-tradable goods.
Japan allowed its currency to appreciate steadily and significantly for many years during the 1990s, with little effect on reducing or eliminating Japan’s then large current account surplus. What Japan got from the appreciation of the
yen was little more than a decade of deflation. If Japan had held its nominal exchange rate constant throughout the 1990s, it would most likely have faced limited inflation during that period. But, too great an appreciation of the yen ultimately eliminated the necessity for inflation (even though inflation occurred) and even required some deflation to compensate the excessive appreciation of the yen.
Moreover, sustained current account imbalances, which are fundamentally about surpluses or deficits of capital, about savings and investment gaps, and about consumption and saving behaviors, have very little to do with the level of the nominal exchange rate.
You, a banker, have a tendency to simplify way too much.
You may also want to read this abstract:
"Based on whether the Chinese and the U.S. interest rates and exchange rate agreeing with covered interest rate parity theory or not, granger causality test and co-integration test were utilized to analyze Chinese and the U.S. interest rates and exchange rate from the perspectives of the relation and the transmission mechanism of them. The research found that, without regard to institution and economic environment factors, the interest rate parity theory was nearly tenable; when the effects of the institution and economic environment factors was comparatively strong, interest rates of China and the USA influenced each other directly. Otherwise, they influenced each other by exchange rate. Finally, conclusions and policy suggestions were pointed out."
Digital Library
You may also want to read the following:
The Hindu Business Line : The renminbi challenge
And this rather simplistic report:
Powered by Google Docs
Additionally, PPP analyses differ on the extent of undervaluation of the yuan based on the method of economics used: by as much as 0-40%. Estimates by Jarvis & McKay, for example, show that the yuan is infact at purchasing power parity. There is also significant disagreement on the extent of undervaluation of the yuan: with figures ranging from 40% (U.S. National Association of Manufacturers, as is their interest) to 14% (Japan's Ministry of Finance) making the political dictum all the more problematic.