China faces mounting pressure to revalue its allegedly undervalued yuan. I am concerned that China could repeat the mistakes that Japan made in exchange-rate policy. China can learn much from Japanese experiences in economic management and currency diplomacy.
What were the mistakes made in Japan’s economic management?
When a new industrial power continues to increase productivity through active investment, its currency tends to become undervalued, as was the case with the yen in Japan’s high-growth era. It made it possible for Japan to develop an enormous production capacity that far exceeded domestic demand. This is how an intractable supply-demand gap came into being, which Japan has had to fill with exports and fiscal spending.
Japan’s trade surplus reached a level that the international community would not tolerate. The Plaza Accord was an attempt to correct the yen’s undervaluation. Following the accord, the dollar’s value plunged from then 240 yen to less that 80 yen in April, 1995.
This has left a devastating three-fold impact on the Japanese economy.
First, Japanese manufacturers increasingly relocated their production plants overseas. Domestic production has been directed to more sophisticated products. As the yen’s rise was too steep, the employment created by more sophisticated industries failed to offset those lost through the shift of plants to overseas locations.
Second, the excessively expansionary monetary policy to fight an economic slump caused by the yen’s rise led to the bubble economy. When the bubble collapsed, asset deflation ensued.
Third, increased fiscal spending to deal with the post-bubble recession culminated in the current budget crisis.
Thus, today’s weakened industrial base, asset deflation and budget crisis all stemmed from the Plaza Accord. If we go further back, we can find that the initial problem was the excessive undervaluation of the yen in the high-growth era.
Now, let’s turn to Japan’s currency diplomacy and its implications for China.
In the international community there is a perception that China’s strong export competitiveness reflects the yuan’s undervaluation. However, opinion is divided in China over this question. Many seem to support the view that, considering its huge population of very poor farmers, the Chinese economy is still vulnerable to shocks from outside and would be unable to withstand the effects of a revaluation. However, what matters for trade balances is purchasing power parity in tradeables (goods and services that can be imported or exported).
Chinese leaders have contended that stability in the yuan’s exchange rate is essential to stable growth of the Chinese and global economies. The question is how long they will maintain its position. The longer they wait,the more undervalued the yuan will become. Japan’s policy mistakes show that if China stays with the undervalued yuan too long, it could develop a supply-demand gap of the same magnitude that has tormented the Japanese economy.
What is the lesson for China currency diplomacy? On Oct 19, U.S. President George W. Bush urged Chinese President Hu Jintao to revalue the yuan, but Hu replied it would be premature. Bush and Hu agreed, however, to establish a bilateral commission to study the exchange rate system, including a shift to floating.
It could lead to a nasty result for China. The United States has a tradition of proposing the establishment of a bilateral study group when negotiations make little headway. Years ago, Japan and the U.S. established a number of such groups on mostly trade issues. When they did not produce results satisfactory to the U.S., Washington applied strong pressure on Japan to let the yen rise. The market responded at once and the yen surged. This is how the market decides exchange rates.
U.S. economic diplomacy reflects domestic politics. To reduce the U.S. trade deficit, Washington has traditionally urged its trading partners to revalue their currencies, instead of raising taxes or cutting fiscal spending (which would cause public disapproval). In the U.S., there is a growing perception that China is resorting to an unfair trade practice by pegging the yuan to the dollar through market intervention.
If China agreed to revalue the yuan moderately, the U.S. might argue it was “too little, too late.” The market would interpret it a signal that the U.S. wants even a higher yuan.
Even if yuan’s value were to rise to a level satisfactory to Washington, its trade deficit would not decrease appreciably, since it would continue to lack an economic policy discipline for controlling domestic demand. Then, it may appear that a rise in the yuan’s value is insufficient and would likely cause Washington to make repeated demands for further appreciation of the yuan — as in the past U.S.-Japan disputes. Would Beijing be able to withstand Washington’s pressure?
It is unfortunate that the yuan problem has become a focal issue in international politics under Japanese-U.S. pressure. Beijing probably would like to avoid revaluing the yuan under Washington’s pressure, but could not afford an outright confrontation with Washington.
One solution would be for China to formulate a grand design of a currency system that would contribute to stable growth of the world economy and would be in China’s long-term interest, and use that as a basis for negotiations with the U.S. It would be more effective for China to propose such a system as a part of an Asian currency system.
There must be a reason for China’s growing interest in a common Asian currency. It is time for both China and Japan to recognize that they would lose out in separate negotiations with the U.S.
French and German political leaders shared such recognition in creating the European Monetary System, which led to the birth of the euro. It was also a peace movement that institutionalized their determination to not let a war in Europe happen again.
Should Japan and China, which have on-and-off disputes over issues of history, cooperate on the development of an Asian common currency system, they could transcend mere currency problems.
There is a question of timing. Bush would wish to see a result in time for the 2004 U.S. presidential campaign, however, it would take much longer for Japan and China to study it. At the very least, the two countries should make an urgent political decision for a joint study.