Perils of undervalued yuan

by Mamoru Ishida

I am concerned that China could repeat Japan’s mistakes in economic policy. In Japan’s high-growth years, the yen became increasingly undervalued, pegged at 360 to the dollar, while the nation’s productivity kept increasing. Exports were profitable and the manufacturing industries built up excess production capacities. Japan’s trade surplus grew beyond an internationally tolerable level, leading to the 1985 Plaza Accords, which forced Japan to accept excessive appreciation of the yen and to expand domestic demand.

Theoretically, the yen’s overvaluation should have reduced Japan’s trade surplus in about two years, but that did not happen. Only in recent years did the trade surplus begin to decline through Japan’s deindustrialization and closure of many factories. This process was painful, for production capacities existed in individual companies and supported many people’s lives.

Continuous fiscal spending to stimulate domestic demand has created an economic structure in which the economy would collapse without annual budget deficits equivalent to at least 6 percent of gross domestic product. This is the basic cause of Japan’s budget crisis.

Since 1994, China has maintained a de facto fixed exchange rate system, with one U.S. dollar pegged at about 8.3 renminbi (RMB) yuan. In the intervening years, China has steadily improved its productivity. As a result, the RMB is said to be valued at a quarter of its real purchasing power.

China is already a major exporting nation, and if the RMB remains undervalued for long, China’s production capacities will increase further; excess supply over domestic demand will grow. If attempts are made to compensate for the supply-demand gap with fiscal spending, the government debt, already at a high level as a result of fiscal expansion for economic stimulation, will grow even more.

The problem is likely to worsen as reforms take hold at state-owned enterprises and banks amid efforts to improve the social security system. If mass fiscal spending every year is deemed politically unavoidable, China could fall into the same pitfall as Japan did.

The United States suffers from the largest trade deficit with China among its trading partners. At a session of the U.S. Senate Banking Committee, a senator suggested a Plaza Accords-like agreement with China. I hope that Chinese officials will take note of this episode, which showed the U.S. could apply strong pressure for a higher RMB.

It would be enough if U.S. officials whispered suggestive remarks in the market to drive up the RMB as it did with the yen in the late 1980s and the early 1990s. It would be naive to think that China could control market speculation since it regulates capital transactions.

In 1971, when Japan restricted capital transactions, I was working for Itochu Corp.’s London branch. I remitted a large amount of U.S. dollars as advance payments to the company’s Tokyo office to prevent a foreign-exchange loss in anticipation of the yen’s revaluation, which occurred in December 1971 at 308 yen to the dollar. Since China is already an economic giant, stability in the RMB’s exchange rate is crucial not just for the Chinese economy but for the world economy.

With this in mind, I suggested at a symposium of the Chinese Association of the World Economy held at Zhejiang University in April that China should correct the undervaluation of the RMB sooner rather than later. Chinese economists paid attention to my presentation, although China often reacts strongly against Japanese industrialists’ suggestion to revalue the RMB.

The economists are concerned about China’s fiscal future and aware of the need for a more flexible foreign exchange rate system that will reflect market realities, especially because China’s will become an integral part of the global market economy as a result of its entry into the World Trade Organization. Chinese plans for opening the domestic financial market and gradually liberalizing capital transactions will lead to sharper fluctuations of the RMB.

He Liping, professor at Beijing Normal University, believes that regional monetary cooperation in Asia will help stabilize such fluctuations. For Japan, stability in the yen’s exchange rate is one of the prerequisites for ending economic stagnation. It is incumbent on both Japan and China to establish systems for stabilizing their exchange rates at appropriate levels, if possible, within the framework of Asian monetary cooperation to minimize any adversary effects on other Asian countries’ exchange rates.

The Asian currency crises of 1997 and 1998 showed that exchange-rate stability in Asia is essential to the prosperity of the Asian and world economies. Li Xiao, professor at Jilin University, told the April symposium that Asian countries should start with cooperation in exchange rate policies, then move on to a currency basket system and eventually create a common currency. It is encouraging to observe a broad consensus on such an idea emerging among many Japanese and Chinese economists.

While Sino-Japanese cooperation is essential, political distrust between the two nations makes such cooperation difficult. I was told that pro-Japanese economists in China were dismayed by such events as Prime Minister Junichiro Koizumi’s visit to Yasukuni Shrine. They hope that Japan will not make Sino-Japanese cooperation more difficult.

By admitting its past mistakes, Germany won the trust of other European countries and joined France in playing a leading role in the European integration. Japanese political leaders are responsible for gaining the trust of other Asian countries and creating a political environment conducive to regional cooperation.