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China’s Self-Defeating Currency Policy

John Lee

China’s trade surplus in April hit $11.4 billion, four times more than almost all economists expected, and the surplus with the U.S. is at its largest since November. During the current round of the U.S.-China Strategic & Economic Dialogue in Washington, Treasury Secretary Timothy Geithner has therefore intensified calls for Beijing to hasten the evaluation of the Chinese yuan. Although American officials have expressed hope that the tone of their Chinese counterparts on this issue is different, little has actually changed. China will maintain nothing more than a slow crawl in revising the value of the yuan against the dollar. It might seem that Beijing is pushing back against U.S. hectoring on the currency, but in reality Chinese intransigence on this issue has less to do with standing up to the Americans and more to do with Beijing’s perception of what is best for the Chinese Communist Party (CCP).

The Party is taking a hard line even though stalling the currency’s rise is not what’s best for China’s economy. Privately, Chinese economists have long argued that the revaluation of the yuan upward is in China’s long-term interest. As these economists consistently warn, China’s unbalanced economy depends too much on domestically funded fixed investment and exports to drive growth and not enough on domestic consumption. China’s imports around half its basic consumer goods as well as fuel. But with inflation currently running at 5.4 percent, even Chinese officials acknowledge a stronger yuan would help them contain inflationary pressures.

Yet, while the role of China’s top economists is to point out structural deficiencies in the economic model and suggest solutions, Beijing’s policymakers have one overriding preoccupation: remaining in power. Sure, the inflation rate is above the desired range of 3-4 percent, but it’s not yet out of control. When it comes to holding on to political power in China’s authoritarian political economy, maintaining jobs in urban regions is still more pressing than price control and macroeconomic rebalancing.

How serious is the labor problem? Although China’s unemployment rate is a respectable 4-5 percent, these figures measure less than one 10th of the more than 700 million workforce. Local officials frequently admit that joblessness is probably more than double the official numbers released by their provinces. China lost an estimated 40 million export-related jobs in the first few months of the global financial crisis, which is the main reason Beijing abruptly halted the yuan’s 21 percent rise against the dollar that occurred from 2005 to 2008.

In addition, a stress test of more than 1,000 exporters in the first quarter of 2010 suggested that Chinese companies were operating on margins of 4 percent or less. Even though it is widely suspected that many Chinese exporters underinvoice to exaggerate their hardship in order to receive subsidies and reduce taxes, they are nevertheless also under pressure from reported wage rises of 10-20 percent in many export sectors.

The objective of protecting the export manufacturing sector is partially to offset the increasingly inefficient job-creation problems in the Chinese state-led growth model. When it comes to economic growth, China has moved from being an export-oriented to a domestically funded, fixed-investment-dependent economy. Over the past decade, fixed investment has been behind just under half the country’s GDP growth, rising to around 90 percent of GDP growth from 2009 to 2010, before falling to 50-55 percent currently. Normally, around three quarters of all bank loans are given to state-controlled enterprises, and an increasing amount of that goes to local government-owned entities.

While the state sector expanded from 2008 onwards, the private sector has actually shrunk in both relative and absolute terms. This is important because private businesses are two to three times more efficient at job creation (in terms of jobs created per unit of capital invested) than the state sector, with the export manufacturing sector the standout. The CCP simply cannot allow the export sector, which employs between 150 million and 200 million people, to shrink.

There is another reason protecting the relatively vibrant export sector matters. An estimated two-thirds of recent college graduates cannot find work commensurate with their qualifications within the first 12 months of graduation. The best jobs are with the government, state-owned-enterprises, or the export sector. With the first two sectors becoming increasingly inefficient at creating employment, Beijing does not want to handicap the latter.

Delaying what economists see as the inevitable revaluation of the yuan upward only leads to more hot money entering the country in anticipation, making Chinese inflation that much harder to control. The problem could possibly be circumvented by a sudden, large, and one-off appreciation against the greenback—say, 10 percent. But Beijing will consider the immediate hit to the export sector as unacceptable.

There are other reasons why Beijing is unlikely to move significantly on the currency issue. For example, the U.S. dollar assets of China’s central bank, the People’s Bank of China (PBC), would take an instant hit from a stronger yuan. The PBC has also forced its domestic banks to accept low-yielding central bank bills and government bonds in exchange for dollar receipts from the country’s exporters to mop up excess liquidity in the system arising from the huge export surpluses. This means the PBC will have to use its U.S. dollar assets on an ongoing basis to cover IOUs to the country’s banks when these central bank bills and bonds mature. Raising the yuan significantly would make this sterilization process much more expensive for the PBC.

For Chinese economists, more efficient job preservation and improving job creation can be done only by reorientating the system in favor of China’s more dynamic domestic private sector. China would then rely less on the export sector to sustain employment. But this would mean the CCP loosening its grip on economic, and eventually political, power. And in a country where there were already an estimated 124,000 instances of mass unrest in 2009—albeit mainly in rural areas—this is the less likely option.