Stanford economist Ronald McKinnon's "Exchange Rates under the East Asian Dollar Standard", just released by MIT Press, argues against adjusting exchange rates to fix trade imbalances. In an interview with China Economic Review, McKinnon maintains that pressure on Japan, Taiwan and South Korea to revalue their currencies had no impact on their trade surpluses with the United States. The problem with America's trade deficit, he says, lies in the US. Excerpts:
Q: You say that the US trade deficit with China has more to do with America's low savings rate than with the exchange rate. What happens when a major US trade partner revalues its currency?
A: Goods in East Asia are almost all dollar-invoiced in foreign trade so when the Chinese currency appreciates, it makes foreign direct investment into China less attractive. Insofar as the Chinese are holders of dollar assets, they would take a capital loss measured in renminbi and so the combination of these two things would mean imports would decline. And, although exports would become more expensive – because of the appreciation – with the fall in income and the fall in imports, you can't predict what would happen to the net trade balance.
Q: After the Plaza Accord forced the yen up in value, Japan reduced its costs by moving manufacturing out to Southeast Asia…
A: The East Asian countries are a sort of bloc that runs a large trade surplus with the US. Individual countries can have different experiences. China's net trade surplus multilaterally is not all that big. It's only about 2% of GNP. Japan's is bigger; Taiwan and Singapore have very big current account surpluses with China; and China has a big surplus with the US bilaterally. So the whole thing is like a big machine exporting into the American market. China is sort of the front man, but behind it are all these [components and raw materials] pouring into China from Japan, Taiwan, Singapore and other countries. So the main thing to understand is that changing the exchange rate of the East Asian bloc vis-?-vis the US will have no predictable effect on the US trade deficit other than a slowdown in growth of East Asian countries on the dollar standard. So you have to look for another explanation of such a large current account deficit. And this is where you look at the very low saving in the American economy – and the high fiscal deficit.
Q: How do savings rates compare?
A: American household savings are meager, probably less than 1% of GNP, whereas in East Asia, household savings can be 25% or 30%. You need household savings in the banking system to finance firms. But the US has hardly any, so US corporations instead draw on foreign savings, which have to be used to build up the normal level of investment in the US and to cover the government's fiscal deficit – and that's how the current account deficit adds up to 5% or 6% of GNP.
Q: What lessons might the US and China draw, looking at Europe's and Japan's sharply appreciated currencies?
A: If you look at Europe, with the euro, it's a more autonomous bloc than East Asia, so the dollar is not so dominant in intra-European trade, and Europeans lend in the world economy in their own currency more. And so, when the euro appreciates as it has – a lot, 30% or so in the last two years – this slows down the European economy. France and Germany are not doing so well in terms of economic growth, but it's not really devastating – whereas if you have an East Asian economy where all the trade around it is dollar- invoiced, and there are big holders of dollar assets within these economies, then an appreciation has a much stronger negative impact on output. So that's the big concern with China now – if they let go [of the peg], it's like being hit over the head in terms of economic growth, and they could suffer as Japan did with various appreciations of the yen from the mid '80s through the 1990s.
Q: Except in China, given unemployment, the impact would be devastating. Why is Washington so blind to these lessons?
A: It boils down to two things. The US government is always under mercantile pressure to do something, and, of course, they'll file antidumping suits and so forth. The WTO, fortunately, doesn't permit arbitrary increases in tariffs. However, the exchange rate is something that could potentially be manipulated, and various [administrations] have thought of getting foreigners to appreciate their currencies as a way of taking pressure off American industry. That was very true during the Japan-bashing period in the 1980s through the mid-1990s. The US government tends to listen to these arguments because they have a faulty theory of the trade balance – the idea that the country with the trade surplus should be forced to appreciate its currency to reduce the surplus. Every undergraduate studying international finance learns the elasticities model of the balance of trade – that when you appreciate your currency, the trade surplus should diminish. But there is an error in the model in that it assumes that the level of output or total spending in each economy remains unchanged. And what happens is, when you have an appreciation in an East Asian economy, income slumps and absorption slumps.
Q: Any way to make Washington see the light?
A: It's convenient politically to shift the blame to the exchange rate and avoid correcting the fiscal deficit and doing something serious about raising the rate of personal savings. The only argument I might make that might influence the American government is not the usual one?which is, if you keep running these deficits, you'll get higher interest rates, a credit squeeze and a downturn in the economy. That's not been true because all these Asian central banks keep buying dollar assets to prevent their currencies from appreciating. So that argument doesn't work, but there is a second argument: that the huge current account deficits have been largely embodied in a trade deficit in manufactured goods. This is a transfer problem – if you're going to transfer savings from foreigners into your economy, there has to be a real embodiment of this, and embodiment of the current account deficit is almost equal to our deficit in manufactures. So our imports in manufactures far exceed our exports in manufactures. That reflects the savings deficiency and manufactures are the natural tradable good. Since the 1960s, the percentage of the US labor force employed in manufacturing has fallen from 24% to 10.5%. There is a natural decline in manufacturing employment in all mature economies – but in the US, the fall has gone further and steeper than in other industrial countries. Japan, which has had the most persistent current account surplus in the last 20-30 years, has had the least fall in industrial employment. My rough calculation is that if the US did not have a current account deficit and a savings deficit, and therefore minimal deficit in trade in manufactures, then labor in manufacturing would be around 14% of the labor force rather than 10.5%. That doesn't sound like much, but it's 4m or 5m workers. This doesn't mean unemployed workers, because they get absorbed into services and other activities – but the rapid decline in manufacturing represents the deindustrialization of the US. And since manufacturing is the sector with the highest productivity growth on average, this is a pretty big long-term loss to the economy. So if I was trying to make a case to George Bush regarding why he should fix the fiscal deficit, I would say 'you should really aim for a surplus to stem the decline in manufacturing.'
Q: You argue for widening the exchange rate band on the yuan – won't that lead to an inflow of more speculative money?
A: I don't think it's a problem. You want to convert the foreign exchange market from something run by the government to an inter-bank market run by commercial banks. If you fix the exchange rate too closely, all the clearing of international payments has to take place at the People's Bank of China. If you make the margin a little bigger, commercial banks can see a profit in clearing international payments, forward contracts and options for their customers. Is the current margin of 0.3% either side of 8.28 (to US$1) enough? I don't think it is, which is why I suggest the margin should be raised to 1% either side. If you try with too big a band, you lose the credibility of the central exchange rate of 8.28. What is very important is that China retain absolute credibility and not let its exchange rate vary substantially.
Q: One hears things like a 5% adjustment coming…
A: That's worse than nothing. It just undermines the credibility of the existing rate. The Chinese have had 10 years of a fixed rate – almost a parity rate – and if you adjust it, people immediately think you may adjust it again and that's 10 years' investment in getting this credibility [lost]. The other part of it is, if the Chinese attempt to float and let it go, there's no well-defined upper bound. The private sector within China has really been frightened about holding dollar assets for fear of them depreciating in value against the RMB. You can't have a normal forex market unless there are a lot of people willing to go long on dollars and short on RMB to match those who want to go long on RMB and short on dollars. You've got to have some sort of matching. By pushing for this appreciation of the RMB, you undermine the willingness of people to take long dollar assets in the private sector. If the Chinese let go [of the peg], you'll get an upward spiral in RMB – very much like Japan in the 1980s. The Bank of Japan, having lost credibility, had to come back and put a cap on it anyway. And that just slowed down the economy. I think it behooves all of them – China, Japan, Singapore and others – not to change their rates.