The latest Economist cover story and leader, America's fear of China, explains why bashing China over trade is not a good idea. But the more interesting piece is inside: Lost in translation. It argues that "If China sharply revalued the yuan, as American politicians are demanding, it could actually hurt the United States and help China." It's a long piece that is worth reading. Below I excerpt the section which claims that the standard arguments for a revaluation are based partly on a series of myths (emphasis added).
The first myth is that there is overwhelming evidence that the yuan is grossly undervalued. China's large bilateral trade surplus with America proves nothing. It largely reflects Asia's changing supply chain. Much of what America buys from China today once came from Japan, South Korea and Taiwan. China now imports components from these countries, assembles them and exports the finished goods to America. Knock out these and America's bilateral deficit with China shrinks by more than half. Even so, China's overall current-account surplus is also huge. The surge in its foreign-exchange reserves, to over $1.2 trillion, also suggests that the yuan is undervalued: without those massive purchases of dollars, the currency would have risen.
However, not all economists agree that the yuan needs to be sharply revalued. At one extreme is Morris Goldstein, of the Peterson Institute for International Economics, who argues that the yuan is undervalued by 40% or more against the dollar and should immediately be revalued by 10-15%. In the other corner many highly respected economists, including Robert Mundell, an economics Nobel prize-winner, and Ronald McKinnon, of Stanford University, strongly argue against a big appreciation of the yuan.
Economists find it devilishly hard to define the “correct value” for a currency. On purchasing-power parity (PPP), the yuan is clearly undervalued against the dollar. Perhaps by as much as 50%. But PPP is not useful for determining the optimal exchange rate between two countries of such different levels of income. It is natural for average prices to be lower in poorer countries because wages are lower. As countries get richer and their productivity rises, their real exchange rates appreciate. And although the depreciation in the yuan's real trade-weighted value since 2002 looks perverse, this follows a real appreciation of 50% between 1994 and 2001 (see chart 1).
A study by two IMF economists, Steven Dunaway and Xiangming Li, found that estimates for the undervaluation of the yuan ranged from zero to nearly 50%, depending on which method was used. Another recent study, by Yin-Wong Cheung, Menzie Chinn and Eiji Fujii, concluded that using conventional statistical methods it is hard to prove that the yuan is much undervalued. Such uncertainty may partly explain why America's Treasury Department has so far ducked labelling China as a currency manipulator in its twice-yearly report to Congress. Another reason is that it is loth to give ammunition to the protectionist lobby.
Myth number two is that the sharp increase in China's trade surplus is due to an explosion in cheap exports. Until 2004 China's surplus was relatively modest, but it soared over the next two years (see chart 2). Jonathan Anderson, chief Asia economist at UBS, points out that export growth actually slowed between 2004 and 2006 (see chart 3). The main reason for the bigger trade surplus was a sharp slowdown in the annual real growth rate in imports, from more than 30% in early 2004 to less than 15% last year.
The entire increase in China's trade surplus since 2004 has come from trade in heavy industrial materials and equipment. China used to import increasing amounts of steel, aluminium, chemicals and machinery, but import growth collapsed after 2004 when the government started to tighten policy, causing a sharp slowdown in construction, one of the biggest importers of machinery and materials. At the same time China continued to invest heavily in metals and equipment, creating substantial excess capacity, so import growth remained relatively weak last year. Mr Anderson argues that imports should recover as overcapacity is used up.
The third fallacy is that imports from China destroy jobs and harm the American economy. It is hard to see how China can be blamed for job losses when America's unemployment rate (4.5%) is close to its lowest for decades. Trade with China may affect the composition of jobs in America, but it has little impact on total employment. It is true that some workers are harmed by trade with China, just as there are some losers from all international trade. But the American economy overall is better off, so in theory there is ample room to compensate any losers.
Trade with China helps, not harms the average American. Thanks to imports from China, prices are lower and real incomes higher. Commentators often refer to the “cheap” yuan as being an unfair subsidy for Chinese exporters. But it is a moot question who exactly is subsidising whom. Not only do cheap imports subsidise American consumers, but China's large purchases of Treasury bonds also hold down American interest rates, thereby subsidising home buyers. Suppose that overnight the yuan rose by 30%, what would happen? American interest rates would rise as China needed to buy fewer Treasury securities and prices at Wal-Mart would increase. If consumer spending and imports then collapsed, this would certainly reduce America's trade deficit, but in a much more painful way than most Americans have in mind.
UPDATE: Greg Mankiw links to and posts an excerpt from a 22 May Wall Street Journal article on the yuan by Matthew J. Slaughter