Back in the 1970s and ‘80s, a sure vote-getter in the US and pleasure-getter on Capitol Hill was to complain about Japan’s manipulating its exchange rate. Every argument that you may hear today about China was made then. In the end, Japan caved in and appreciated its exchange rate. This is shown in Figure 1, which displays real effective exchange rates, i.e. exchange rates corrected for the evolution of the country’s labour costs relative to those of trade partners. As seen from Figure 2, the US current account deficit improved, but only temporarily, and Japan remained in surplus after a temporary reduction. What the move has achieved durably was to wreck the Japanese economy, which has not grown ever since – the Japanese used to call this “the lost decade”, it is now becoming a lost generation. As China emulates Japan’s export-led growth strategy, this story is likely to figure prominently on its policymakers’ minds. Rightly so. (For development of this story see Park and Wyplosz 2010).
Figure 1. Real effective exchange rates (2005 = 100)
Source: IMF. Note: Nominal exchange rates corrected for unit labour costs. An increase represents a real appreciation
A confusing debate
Figure 2 illustrates the dangers of interpreting comovements as causality. The striking feature is the opposite movements – or negative correlation – of the US and Japanese current accounts. Equally strikingly, in spite of these wide fluctuations, for more than 30 years the Japanese account has not been into negative territory while the US has not seen a surplus. US legislators interpreted these opposite yo-yo movements as a proof that the US deficits were caused by the Japanese surpluses and they saw the continuing Japanese surpluses as a proof that the yen was overvalued. They say exactly the same things today, just cut out “Japan” and replace it with “China”.
Figure 2. Current accounts (% of GDP)
But there is a big problem. The negative correlation between the US and Japanese current accounts is still very much there. So if yesterday’s Congress members were right, then it must still be that the US external deficit continues to be driven by Japan’s surplus. You do not need to bring China into the picture. Alternatively, if you agree with today’s Congress, you didn’t need Japan back then, maybe China was already doing the trick (it wasn’t). The other possibility is that both China and Japan have been colluding all along, which would require an incredible amount of coordination between two countries that are barely on speaking terms.
China’s authorities naturally see causality running in the other direction. They blame the US current account deficits for the Japanese and Chinese surpluses. They further blame the US budget deficits for their external deficits. The US response has been the “saving glut” hypothesis originally proposed by Bernanke (2005). This view argues that excess savings in China (about 40% of GDP) both depress imports and create the need for investment opportunities abroad. Thus politicians look at the current account and competitiveness, therefore the exchange rate, while Bernanke looks at capital flows – the Chinese savings are transformed into US (public sector) borrowing. This removes the exchange rate from centre stage.
Some (hopefully) clarifying observations on causality
Causality lies at the heart of the dispute, as is often the case. As economists, we know how delicate the causality issue is. Theoretically, in general equilibrium few are the truly causal – or exogenous – factors. Empirically, causality is the most vexing issue, which has led to countless techniques, none of which are particularly convincing. The first observation, which is neither clarifying nor hopeful, is that it is impossible to prove which side of the debate is guilty.
In particular, no one will seriously claim that current accounts are exogenous. Debating whether it is the US deficit that is causing China’s surplus or the other way around is a waste of time. The negative correlation only shows that these variables are related to each other. We must try to understand what is driving both. US budget deficits, Chinese and US savings and a few other variables are good candidates; more on them below.
Another aspect of the causality problem is the role of the exchange rate. Is the Chinese current-account surplus caused by a renmimbi undervaluation? Put differently, is the renmimbi exchange rate exogenous? The answer is not as easy as it may seem. Of course, the Chinese authorities peg their exchange rate to the dollar and even when they allow for some flexibility (before the crisis and soon again), they still very much keep it under control. Undoubtedly, the nominal exchange rate of the renmimbi can be taken as exogenous, but it is the real exchange rate, i.e. the relative price of domestic and foreign goods or relative unit costs as in Figure 1, that affects the current account.
Does the renmimbi exchange rate matter?
Let us start with the object of conflict, i.e. the dollar-renmimbi exchange rate. The nominal rate is in the hands of the Chinese authorities, who have opted for a fixed exchange rate regime. This is perfectly compatible with IMF principles. Calling that manipulation is not just outside any legal norm, it would also concern the tens of other countries that also peg their currencies to the dollar – and (why not?) those that maintain fixed exchange rates vis-à-vis currencies like the euro.
But is this peg responsible for the Chinese surplus and the US deficit? Start with the easier part of the question: the link between the Chinese current account and the value of the renmimbi. If the exchange rate has any impact on the current account, it is because it affects price competitiveness, which can be approximated by the real exchange rate. The evidence here is not controversial: the nominal exchange rate strongly affects the real exchange rate in the short run, say over one year or two, but not in the long run because real exchange rates eventually are endogenous. The claim that the renmimbi undervaluation is the cause of continuing Chinese surpluses look like a nonstarter, unless it can be proven that China also prevents prices from rising in response to undervaluation.
Like every country, China tries to stabilise prices. The instrument is monetary policy, which in China is essentially driven by the fixed exchange rate policy. Put differently, the exchange rate is the instrument used to keep inflation low. If the authorities were to peg it at the wrong level, the result would be inflation. This does not fully exonerate China, however. Because they use extensive internal and external financial controls, the Chinese authorities can peg the exchange rate at an undervalued level and combat inflation through credit controls. This is precisely what they do. So, yes, it is possible for China to control its real exchange rate for more than the short run. Put differently, the export-led strategy is still an option.
This conclusion, however, does not imply that the renmimbi exchange rate can explain the US deficit. The US cannot control its own real exchange rate and, anyway, it does not even attempt to control its nominal rate. Then is the dollar overvalued? That raises the question: what is the dollar equilibrium exchange rate level? The formal definition of equilibrium is complex – the real rate that, if maintained indefinitely would allow the country to run permanently surpluses, respectively deficits, that allows it to serve its external debt, respectively to absorb returns on its net external asset position. A simplified version, inevitably inaccurate, is that the real exchange rate is in equilibrium if it delivers a current account balance when the economy is otherwise in a sustainable position. The problem is that the US quasi-zero private saving rate until 2008 and its budget deficits observed over the last decade are not sustainable. Whether the dollar is in equilibrium or not is therefore highly controversial. A safe conclusion is that a renmimbi appreciation, even a large one, will not solve the many disequilibria present in the US economy. US citizens must first start saving again and the federal government must stabilise its own indebtedness. The role of the renmimbi is bound to be negligible.
What is the story, then?
A good story must distinguish between short-run comovements of the US and Chinese current accounts and the long-run trend of larger imbalances visible since the mid-1990s, both of which are negatively correlated. The saving glut story offers an interesting starting point. It takes Chinese savings as exogenous. High savings are seen as the result of Asians’ famed propensity to save combined with income distribution tilted towards large firms and with inexistent social safety nets. It is also a highly desirable feature when the population is quickly ageing, as is indeed the case in China. Fast growth and more resources flowing to high savers explain the trend seen in the left-hand chart in Figure 3.
The next step is the trend decline in US net private saving (for the time being, ignore the wide shorter-run fluctuations) also shown in the left-hand chart in Figure 3. This is mirrored in the growing US current account deficit. No need for China and the renmimbi to account for this evolution. It just turns out that the current accounts of China and of the US started more or less simultaneously in opposite directions.
For the shorter-run movements, we turn to the right-hand chart in Figure 3 which displays the US current account and its two components: the budget balance and net private saving. The striking observation is the near perfect negative correlation between the budget balance and net private saving. This observation suggests – remember, causality is hard to prove – that net private saving fluctuations in the US have been largely driven by the budget balance, in Ricardian fashion (Ricardian equivalence asserts that the private sector saves exactly what the government dissaves because it understands that the public debt must be eventually financed by higher taxes).
In a pure Ricardian world, the current account would have remained in balance, which it approximately did until the early 1990s. This observation came to be known as the Feldstein-Horioka paradox because it meant that the US was not taking advantage of financial markets to borrow or lend internationally. The paradox disappeared in early 1990s when the short-run fluctuations of net private savings moved along a declining trend, which was mirrored in the declining current account deficit. This is indeed when financial deregulation picked up speed around the world. In the US, it led to the development, among other innovations, of the now-infamous subprime mortgage markets. Private saving declined drastically. (The 2008 crisis seems to have brought a reversal, but a couple of years a trend does not make.)
Figure 3. The China-US nexus (% of GDP)
Source: IMF and OECD
Finally, what about the negatively correlated shorter-run current account fluctuations in the US and China (and Japan)? The striking message from the left-hand chart in Figure 3 is that the Chinese current account is most directly related to US net private savings and therefore, via the right-hand chart, to the US budget deficits. Assume that Chinese and Japanese (and German) savers would not have responded to rising borrowing needs in the US. In the now-globalised economy, interest rates would have risen worldwide, presumably encouraging saving. Conversely, if China’s savings had not been matched by US borrowing, interest rates would have declined worldwide, presumably encouraging borrowing. Depending on which side dominated, interest rates played their balancing role – though this remains to be established.
The story can be summarised in a simple, hopefully convincing, way.
- Financial deregulation in the US leads to a drastic decline in US private savings, which translated in a long-run trend decline in the current-account balance.
- At about the same time, China deregulated its economy and embarked on an export-led strategy. Rapid growth put continuously more income in the hands of large firms that started to save more as they could not invest fast enough to absorb their resources. This translated in a long-run trend rise in China’s current account.
- In the shorter run, US budget deficit fluctuations led to opposite fluctuations in US net private savings (along the downward trend, see 1 above). US citizens being imperfectly Ricardian, there remains a residual current account imbalance (along the downward trend, see 1 above) which led to matching saving responses elsewhere in the world, including in China.
- The Chinese exchange rate is not a necessary ingredient in the story. If China insists on pegging the renmimbi to the dollar and on preventing the real appreciation that should accompany fast technological catch-up – the Balassa-Samuelson principle – eventually inflation will deliver this appreciation.
Bernanke, Ben (2010), “The Global Saving Glut and the U.S. Current Account Deficit,” Sandridge Lecture, Virginia Association of Economics, Richmond, Virginia, Federal Reserve Board, March.
Park, Yung Chul Park and Charles Wyplosz (2010), Monetary and Financial Integration in East Asia: The Relevance of European Experience, Oxford University Press.