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Why China has got it right on the renminbi

by Barry Eichengreen

BERKELEY — After a period of high tension between the United States and China, culminating earlier this month in rumblings of an all-out trade war, it is now evident that a change in Chinese exchange-rate policy is coming. China is finally prepared to let the renminbi resume its slow but steady upward march. We can now expect the renminbi to begin appreciating again, very gradually, against the dollar, as it did between 2005 and 2007.

Some observers, including those most fearful of a trade war, will be relieved. Others, who see a substantially undervalued renminbi as a significant factor in U.S. unemployment, will be disappointed by gradual adjustment. They would have preferred a sharp revaluation of perhaps 20 percent in order to make a noticeable dent in the U.S. unemployment rate.

Still others dismiss the change in Chinese exchange-rate policy as beside the point. For them, the Chinese current-account surplus and its mirror image, the U.S. current-account deficit, are the central problem. They argue that current-account balances reflect national savings and investment rates. China is running external surpluses because its saving exceeds its investment. The U.S. is running external deficits because of a national savings shortfall, which once reflected spendthrift households but now is the fault of a feckless government.

There is no reason, they conclude, why a change in the renminbi-dollar exchange rate should have a first-order impact on savings or investment in China, much less in the U.S. There is no reason, therefore, why it should have a first-order impact on the bilateral current-account balance, or, for that matter, on unemployment, which depends on the same saving and investment behavior.

In fact, both sets of critics have it wrong. China was right to wait in adjusting its exchange rate, and it is now right to move gradually rather than discontinuously. The Chinese economy is growing at potential: Forecasts put the prospective rate for 2010 at 10 percent. The first-quarter flash numbers, at 11.9 percent, show it expanding as fast as any economy can safely grow.

China navigated the crisis, avoiding a significant slowdown, by ramping up public spending. But, as a result, it now has no further scope for increasing public consumption or investment.

To be sure, building a social safety net, developing financial markets, and strengthening corporate governance to encourage state enterprises to pay out more of what they earn would encourage Chinese households to consume. But such reforms take years to complete. In the meantime, the rate of spending growth in China will not change dramatically.

As a result, Chinese policymakers have been waiting to see whether the recovery in the U.S. is real. If it is, China’s exports will grow more rapidly. And if its exports grow more rapidly, they can allow the renminbi to rise.

Without that exchange-rate adjustment, faster export growth would expose the Chinese economy to the risk of overheating. But, with the adjustment, Chinese consumers will spend more on imports and less on domestic goods. Overheating having been avoided, the Chinese economy can keep motoring ahead at its customary 10 percent annual pace.

Evidence that the U.S. recovery will be sustained is mounting. The latest data on sales of light vehicles, as well as the Institute of Supply Management’s manufacturing index and the Bureau of Labor Statistics employment report, all point in this direction.

Because the increase in U.S. spending on Chinese exports will be gradual, it also is appropriate for the adjustment in the renminbi-dollar exchange rate to be gradual. If China recklessly revalued its exchange rate by 20 percent, as certain foreigners recommend, the result could be a sharp fall in spending on its goods, which would undermine growth.

Moreover, gradual adjustment in the bilateral exchange rate is needed to prevent global imbalances from blowing out. U.S. growth will be driven by the recovery of investment, which fell precipitously during the crisis. But, as investment now rises relative to saving, there is a danger that the U.S. current-account deficit, which fell from 6 percent of GDP in 2006 to barely 2.5 percent of GDP last year, will widen again.

Renminbi appreciation that switches Chinese spending toward foreign goods, including U.S. exports, will work against this tendency. By giving American firms more earnings, it will increase corporate savings in the U.S. And it will reconcile recovery in the U.S. with the need to prevent global imbalances from again threatening financial stability.

Chinese officials have been on the receiving end of a lot of gratuitous advice. They have been wise to disregard it. In managing their exchange rate, they have gotten it exactly right.

Barry Eichengreen is a professor of economics and political science at U.C. Berkeley. © 2010 Project Syndicate