Commentary Type

China's Revaluation Shows Size Really Matters

Op-ed in the Financial Times


Yesterday, the Chinese government acknowledged what has long been apparent-that the renminbi is undervalued and that China's currency regime needs to be changed. Unfortunately, the reforms that were announced are disappointing in several key respects.

Most obviously, the initial move is far too small. By our estimate, the real trade-weighted value of the renminbi is undervalued by 20 to 25 percent-far in excess of what is implied by an initial 2 percent revaluation with respect to the dollar, along with ambiguous statements about "moving to a managed floating exchange rate regime" and "making adjustment of the renminbi exchange rate band when necessary." China has used similar language to describe its exchange rate system for a decade, but the emphasis has been on management and stability of the rate rather than flexibility, not to mention floating. But the move to a basket peg is positive and should be applauded.

A very small revaluation of the renminbi will not correct China's large balance-of-payments surplus. China's overall current account surplus as a percentage of gross domestic product topped 3 percent in 2003 and 4 percent in 2004. The slight slowing of the economy this year has cut import growth in the first six months to less than half the average pace of the past two years, while export growth has continued at a stunning 30 plus percent for the third successive year. As a result, during the first six months of 2005, the trade balance surplus exceeded the total for all of 2004. China is on track to record a current account surplus this year of 6 percent of GDP or more-a record. China has also recorded large and growing surpluses on capital account as well as significant unrecorded capital inflows in recent years. The result of these trends has been huge increases in China's foreign exchange reserves-11 to 12 percent of GDP during the past two years and possibly as much as 16 percent of GDP projected for this year.

Since a small change in China's exchange rate will do little to affect its balance-of-payments disequilibrium, the only conclusion is that the initial revaluation will set up strong expectations of future revaluations. This will induce even larger capital inflows to China, as market participants anticipate the profits from further revaluations. Larger capital inflows will make it even more difficult than it has been thus far to sterilize reserve inflows and to keep money and bank lending flows under control-without the continuation of strong administrative controls on bank lending, investment project approvals and land use. It is not in China's long-term interest to put stronger controls on capital inflows.

A small appreciation or revaluation of the renminbi will, likewise, have practically no effect in reducing global payments imbalances-especially the large US current account deficit. Even if Japan and the rest of emerging Asia follows Malaysia and allow appreciations similar in size to China's revaluation of 2 percent, the trade-weighted value of the US dollar would fall by less than 1 percent. This is likely to improve the US current account imbalance by about $10 billion (£5.8 billion)-a tiny amount relative to last year's $660 billion deficit.

Nor will a small change in the renminbi silence protectionist pressures in Washington and elsewhere or silence charges that China is engaging in currency manipulation. Indeed, the pressure from the US Congress is likely to accelerate since the Chinese government's argument that they would never change their currency regime in response to external pressure is no longer credible. And it is unlikely that the renminbi could be kept within a narrow band without the continuation of protracted, one-way intervention in exchange markets-the most widely cited indicator of manipulation.

China's small change in its exchange rate policy is consistent with its incremental reform strategy over the past 25 years. Small moves to reform agriculture, foreign trade and state-owned enterprises were followed by further steps that led to far-reaching structural changes. But incremental reform is the wrong strategy in the currency domain, where the disequilibrium is so large and where controlling expectations of future exchange rate changes is essential to internal and external balance.

In 1994, when China acted to unify its currency market, it recognized the need for decisive action. It is regrettable that this time it appears to have acted so timidly on the long-awaited and long-delayed currency reform. This is (another) case where size matters. China should therefore quickly convert its initial move into a significant revaluation from 20 to 25 percent.

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