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Time to aim for better balance in growth

(China Daily)
Updated: 2009-06-25 07:19

Li Weigang, post-graduate student in Harvard University, recently interviewed Jeffrey Frankel, Harpel Professor of Capital Formation and Growth at the university's Kennedy School of Government. Frankel spoke extensively on China's exchange rate policies. Following is an excerpt:

Q: After joining the WTO, China gained some advantages and raised its foreign reserves to $2 trillion. Now many Western countries, especially the US, want it to increase the value of the yuan to reverse their trade deficits. Do you think it's an efficient way to reduce the US' huge trade deficit?

A: US officials began pressing China to abandon its effective peg to the dollar in the fall of 2003. From the beginning, I have viewed these political efforts as misguided.

First, I don't think raising the yuan's value would benefit overall US exports much (as opposed to the effect on bilateral trade with China), especially if other Asian currencies don't rise against the dollar simultaneously.

Second, even if raising the yaun's value boosts US exports, the drop in the purchase of US Treasury bills by Chinese authorities is likely to push up US interest rates. That means the overall effect on US output and employment would be small, even if it is positive.

Third, I think every country is entitled to choose a exchange rate regime that most suits it. It is true that surplus countries should take into account the implications for the world monetary system, particularly via the International Monetary Fund. But my personal opinion is that such exchange rate commitments are not on a par with commitments under WTO trade agreements.

One reason is that it is hard for anyone to identify the correct currency policy. I think that language such as "violation of international agreements" and even "unfair manipulation" is not desirable in such cases, and threats of illegal trade retaliation are especially inappropriate.

Having said that, I do believe that it is in the interest of a large country such as China to allow increased flexibility in its exchange rate over the longer run, and that particularly from 2004 to 2007, this meant allowing the value of the currency to be raised, which would have helped prevent overheating of the Chinese economy.

Q: What are your suggestions on reforming the yuan exchange rate regime in the near future? What if China switches its dollar-denominated foreign reserves to the euro?

A: By moving in mid-2008 from the newly flexible regime - which indeed appears to have put roughly equal weight on the euro and the dollar in 2007 - Chinese policymakers are almost back to the dollar peg.

My answer to the question about the future is that it seems likely that the Chinese authorities will once again jump off the dollar-peg horse. One might expect pressure from Chinese exporters to increase because they have been hit hard by the recession.

On the other hand, US congressmen, Democrats and Republicans both, are still pressing for loosening the link with the dollar. They are oblivious to the fact that the yuan would probably be weaker today if the Chinese authorities had retained the 2007 regime or if they had loosened the dollar link in some other way.

The question about how to hold reserves is different. The People's Bank of China (PBOC) feels there isn't an alternative to the dollar, and it knows that if it started selling dollars the US currency would probably fall sharply, which would hurt China the most. But there are options: especially the euro and some smaller currencies, and even gold and the self-drawing right if the international community accords it a larger role to play. When other dollar-holders start selling the greenback, however, the PBOC wouldn't like to be the only central bank left "holding the bag".

Q: Princeton Professor Gregory C. Chow and Stanford Professor Ronald McKinnon held a debate in 2005 on whether a revaluated yuan would be good for the Chinese economy. But you have suggested that revaluation of the currency is not the only policy change China needs to make. Can you elaborate on that?

A: Prof Chow was clearly right, at least for the period between 2005 and 2008, when overheating and inflation were clearly a bigger danger than deflation. Like every other country China has moved to the recession or disinflation side of internal balance since mid-2008, so that particular reason for revaluation of the yuan is no longer there.

I should also say another reason on the list has changed sharply: a thorough revision of the numbers in the World Bank's International Price Comparison Project a year ago rendered obsolete the earlier estimate of 35 percent undervaluation under the Balassa-Samuelson benchmark. The revised estimate would be something closer to 15 percent (according to Arvind Subramanian, senior fellow at Peterson Institute for International Economics and senior research professor at Johns Hopkins University).

But that doesn't mean I share Prof McKinnon's general fondness for fixed exchange rates. There are still other reasons on the list why China should allow greater flexibility (which, incidentally, under present conditions may no longer imply raising the yuan's value).

My statement that a change in exchange rate policy is not the only policy change that China should make is truer today than when I made it. What China should do - and, in fairness, has apparently begun to do - is expand domestic demand and shift the economy structurally toward such neglected sectors as healthcare, education and the environment, and more generally to build social safety nets and expand the service sector.

The industrialization model led by exports of manufactured goods has accomplished miracles in China, but the time has come to achieve a better balance by developing the rest of the economy. And that will need the government to increase spending.

This interview is part of a project called "China in the Eyes of Harvard - Interviews with Experts on China Issues at Harvard". More than 40 prominent Harvard professors have been interviewed, and their views would be compiled into two books. The China Social Sciences Press will publish the Chinese version, and Harvard University Press, the English.

(China Daily 06/25/2009 page9)