With constant calls for China to allow its currency to appreciate, it is refreshing to read an impressive and constructive case against revaluation. A professor of International Economics at Stanford University, the author's main focus is on the East Asia region and he begins by confirming the obvious – that the East Asian economies have effectively gone back to the soft peg system against the US dollar that dominated the currency market in this region pre-1997 and subsequently has been much maligned by the IMF and others. Now as then these economies are reluctant to float their exchange rates, but for the opposite reasons that prevailed pre-1997.
Prior to the Asian financial crisis, most high-growth countries in the region posted consistent current account deficits. With their domestic currencies unacceptable in international debt markets, this growth was effectively funded offshore through foreign borrowing. By maintaining a soft peg against the dominant currency in Asia, the dollar, the respective governments effectively provided an informal hedge for borrowers against foreign exchange losses on offshore borrowings – the accompanying build up in offshore debt and the abuses by corporates and banks is well documented. Thus the fear of abandoning a soft peg pre-1997 was one of devaluation, which was all too quickly realised.
Post 1997 the situation has changed completely. The five 'crisis' economies have effectively been forced to run current account surpluses. Combined with the larger economies in the region such as mainland China, Taiwan and Singapore posting growing surpluses, the subsequent massive build up in foreign exchange reserves and dollar assets has transformed the region into the primary funding source for the US deficit. The price of this success is that the pressure on the soft peg is now one of revaluation rather than devaluation.
The dilemma that China and other countries now face is what the author calls 'conflicted virtue.' The virtue part comes from the high savings rates in East Asia that facilitated the growth in current account surpluses. The conflict comes from the consequences of these surpluses – pressure from the US for revaluation, accentuated by a flow of dollar assets into the domestic currency by holders worried about (or speculating on) revaluation of their domestic currency. The domestic government then faces a choice. Does it revalue, depressing exports, and risk the danger of deflationary pressure – which could ultimately result in a zero interest liquidity trap? Or does it maintain its currency and risk trade sanctions?
Japan's revaluation experience
The author is in no doubt about which path to choose. In an interesting argument against the appreciation lobby, he points to the experience in Japan where the strong appreciation in the yen from 1971 to 1995 resulted in even larger trade surpluses, and a bubble in land and equity values which, following the subsequent collapse, pushed the country into a deflationary slump and liquidity trap. To further discredit the linkage between an appreciating currency and trade balance adjustment, he points to his own previous research which suggests that the effect of exchange rate movements on the net trade balance of an open economy (East Asia) is ambiguous at best.
Not surprisingly, the author gives top marks to China for maintaining its effective fixed exchange rate against the dollar during the crisis of 1997-1998 and since. He points out that its exchange rate stability has had a largely stabilising effect on its East Asia trading partners (limiting potential competitive devaluations and enabling a quicker post-crisis recovery) while consistent high economic growth in China has also resulted in moderating the fluctuations in its trading partners' business cycles. China now sources over 40% of its imports (2001) from these countries and it is increasingly becoming the anchor economy and export centre for the region. And the wage adjustment mechanism necessary under a fixed exchange rate also appears to be working well, accurately reflecting the differing growth in productivity.
But China now finds itself in a position of conflicted virtue and the author sees ominous parallels to Japan in the '70s and '80s, when the Japanese came under increasing pressure to revaluate the yen. China's position is aggravated by large FDI inflows, up to twice the size of annual current account surpluses since 1997, which have resulted in an estimated net international liquid asset position of almost US$600bn in 2002. In the medium term, McKinnon suggests China can defuse upward pressure on its currency through partial sterilisation of foreign exchange reserves and reducing the current account surplus by faster trade liberalisation. More importantly, he argues that China effectively stick to its guns and regard the 8.28 yuan/dollar as its long term 'parity' rate. This would be the anchor for exchange rate stability in the increasingly integrated East Asia region, helping the other countries to resist the temptation/pressure to allow their currencies to appreciate. In doing so, China would avoid the perils of deflation and slower economic growth and effectively confirm the creation of an East Asian dollar standard.
McKinnon's argument for exchange rate stability will surely go down well in Beijing and other Asian capitals. However, in the US some critics may suggest that the author is crying wolf and that using Japan to illustrate the perils of appreciation is too extreme a case. They may also be reluctant to accept that the Chinese yuan in particular is not undervalued. And vote sensitive US politicians are unlikely to pay much attention. This is a shame as the book is perhaps one of the most rational and impressive arguments against the common call for currency appreciation in the East Asia region.
Exchange Rates under the East Asian Dollar Standard by Ronald I McKinnon; The MIT Press, March 2005; US$35 at www.mitpress.mit.edu Stephen Rogers, who has followed China stocks as an analyst in Hong Kong, headed UBS Research in Jakarta when the rupiah collapsed and wrote The Last Puppet Master (Asia 2000) about Soeharto's downfall, a novel bestselling Shanghai author Christopher New likened to Christopher Koch's The Year of Living Dangerously.
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