Exchange Rates Aren’t the Problem, or the Solution

When President Obama arrives in Shanghai tonight, one of the hottest issues on the table will be the exchange rate between the U.S. Dollar and China’s Renminbi. In the past few weeks, commentators like New York Times columnist Paul Krugman have argued that Obama’s top priority should be to pressure China into strengthening its currency, in order to “rebalance” the global economy. I disagree. A more flexible exchange rate – and the stronger Renminbi that would likely result – would be a step in the right direction. But it’s not a silver bullet, and would have little effect in the absence of more substantive economic reforms. In my view, the focus on currency is a huge distraction from far more pressing issues.

Krugman is correct that a rebalancing needs to take place. The current situation, in which China runs larger and larger trade surpluses, and lends the proceeds back to fuel ever-rising consumption in the United States, is not sustainable indefinitely, especially as the Chinese economy grows to rival America’s in size.

According to conventional economic theory, flexible exchange rates play a vital role in correcting such imbalances. When a Chinese exporter sells a product to the U.S., it receives dollars in return. Those dollars don’t just disappear; they stay in China until someone wants them to buy products from America or invest in American assets. For quite some time now, China sells more than it buys from the U.S., and brings in more capital than it invests abroad, which means that there aren’t enough people who want to use all the dollars that keep flowing in. Just like any other market, when the supply of something – in this case dollars – outstrips demand, its price should drop. The dollar depreciates, making U.S. goods cheaper and more attractive to Chinese consumers, while the Renminbi appreciates, making Chinese goods more expensive in America, eventually closing the gap in trade.

The Chinese government, though, isn’t letting that happen. Instead of letting those excess dollars sell for a lower price in Renminbi, it steps in and buys them at the current exchange rate, and holds them as reserves. By keeping the Renminbi artificially cheap, Krugman and other critics contend, China gains an unfair trade advantage. If only the Chinese would stop interfering, and allow the dollar to find its true level, American products would become more competitive and this dangerous imbalance would correct itself.

Sounds good, but the problem is we’ve been here before. In the early 1980s, Japan was running a chronic trade surplus with the United States, and accumulating dollar reserves on a massive scale. Economists argued that an undervalued Yen was to blame. So in September 1985, the central banks of the U.S., Japan, Britain, France, and West Germany agreed on what became known as the Plaza Accord. Over the course of the next two years, they intervened heavily in global currency markets to bring the value of the dollar down by over 50% against the Yen, from around 250 JPY/USD to 125.

The outcome baffled and frustrated economists. While the cheaper dollar had a significant effect in reducing America’s trade deficit with Europe, Japans’ trade surplus with the U.S. barely budged – in fact, it grew. How could this be? Why didn’t the new exchange rate make U.S. goods more competitive, and erase the trade imbalance with Japan?

The reason was structural. The post-war Japanese economy had been based on export-led growth. Its financial system, supply chains, and distribution channels were all geared to push exports. The cheap Yen was one pillar supporting this structure, but when that changed, other factors swung into effect to maintain the status quo. Following the Plaza Accord, the Japanese banking system flooded the economy with cheap credit to fuel continued expansion, and brushed bad debts under the rug. On the equity side, Japan’s system of corporate crossholdings within keiretsu industry groups tended to produce a greater emphasis on preserving market share than on maximizing profits. The country’s domestic distribution system, virtually impenetrable to outsiders, created a formidable barrier to imports, regardless of price.

Exchange rates are prices, but they only matter so long as prices matter. We normally assume that prices do matter, but soft budget constraints and subsidies embedded in the structure of an economy can blunt or entirely negate the impact prices should have. That’s what happened in Japan.

China, too, has relied on an export-led model to fuel its stupendous growth these past 30 years. With the collapse in overseas demand caused by the global financial crisis, much talk has been devoted to the need to foster domestic consumption as an engine of growth. But China’s actual response to the crisis has been to rely on an explosion of cheap lending and state spending to freeze the existing economic structure in place, in the interests of social stability. China’s stimulus program has tilted the playing field in favor of large state-owned companies which often pursue other goals besides profit and are regarded as “too big to fail.”

An undervalued Renminbi may be part of the problem – its peg to a weakened dollar is certainly putting the squeeze on other countries that compete with Chinese exports to the U.S. But my concern is that, even if President Obama succeeded in pressuring China to strengthen the Renminbi, we’d be looking at a replay of the Plaza Accord. Rather than face a difficult economic adjustment, China would find other ways to bolster its export sector, and the imbalance would persist. America’s interests, and the world’s, would be much better served by encouraging China to open its markets to greater competition, foster capital markets that allocate resources more efficiently, and develop a social safety net that makes labor markets more flexible and unlocks the savings of China’s vast population. The President can also help by sending a clear signal that America welcomes Chinese investment, offering China a more productive way to use the dollars it does earn. If progress is made on these fronts, it well help create an environment in which prices do matter, and exchange rates can make a difference in producing lasting outcomes.

If President Obama wants to achieve real results, he should press China on market-oriented reform, not exchange rates.