Be careful what you wish for on currencies

March 19, 2010

The rancorous argument about global payment imbalances and the yuan’s valuation is exposing a surprising and dangerous economic illiteracy among policymakers and commentators.

Before pressing China to allow a maxi-revaluation of the yuan, western commentators need to think through the consequences carefully. The idea that devaluing the dollar (and by extension euro and yen) will cause payment imbalances to disappear and boost employment in the West with little or no impact on inflation and living standards is a pipe dream.

First some notes about terminology. Proponents generally phrase their argument in terms of an appreciation of the yuan (which keeps the focus on the alleged currency manipulators in China). But it could just as easily be recast as a depreciation of the dollar (which is a much more controversial formulation, highlighting the fact that the exchange rate problem reflects U.S. weakness as much as China’s strength).

Since most observers assume bilateral relationships between the dollar and other major currencies would not alter significantly, China is in fact being pressed to permit a balanced depreciation of the dollar, euro, yen and other major currencies.

Finally, we are not talking about small changes but very large ones. Observers have suggested the dollar might be overvalued as much as 25-50 percent. Devaluing it 5 percent is unlikely to cause a substantial adjustment in China’s trade surpluses with the United States and globally and will not remove the political tensions and the root of the crisis.
Only a very large reduction in the dollar’s value over a period of years, in effect a “maxi-devaluation”, could hope to adjust the relative trade performance of the two countries.

Within the United States and euro zone, the main impact would be to raise the price of tradable goods and services relative to their non-tradable counterparts. Exports would become more competitive while imports would become significantly more expensive. Demand would switch from domestic consumption and imports towards exports and import-competing firms.

Normally, such expenditure-switching adjustments would need to be accompanied by expenditure-reducing tax hikes, spending cuts and interest rate increases to shrink non-tradable industries to expand export and free up resources for import-competing sectors, allowing adjustment without triggering inflation. The combination of expenditure switching and reducing policies is the standard prescription at the heart of an IMF structural adjustment programme in developing countries.

However the recession has already created plenty of slack in U.S. and European manufacturing. Supporters think the United States could achieve a maxi-devaluation, a big rise in exports and a fall in imports without triggering significant inflation or driving the Fed to raise interest rates. Adjustment would be essentially painless.

But this is much too sanguine. Improved competitiveness would eventually expand U.S. exports and import-competing businesses, creating jobs. But it would also boost the cost of imported items substantially, and cut living standards for almost all U.S. and European consumers.

It is important not to underestimate how big the impact could be. Cheap manufactured imports from China and the rest of Asia, combined with easy credit and rising debt, have been the main engine of rising living standards in the United States and some of the other advanced industrial economies over the last 20 years as real wages have stagnated. If imports become significantly more expensive, households will feel much poorer.

Devaluation supporters often suggest China’s manufacturers might absorb a proportion of the exchange rate change to protect market share, cushioning the blow. Apart from defeating the object of the devaluation, there is no way China’s manufacturers could absorb the full impact of the sort of 25-50 percent maxi-devaluation that would be needed to eliminate the payments imbalance, according to some U.S. economists.

While devaluation’s impact on the cost of manufactured imports might be (slightly) lessened, the biggest impact would be on the cost of raw materials such as crude oil and industrial supplies that trade in global markets.

By boosting the purchasing power of Chinese businesses and households, and their consumption of oil and other raw materials, a maxi-devaluation would drive oil and other commodity prices sharply higher in dollar terms, and cut deeply into real household incomes in the United States.

I have written elsewhere that there is no real, fundamental link between oil prices and changes in the dollar’s trade-weighted value. Correlations are mostly driven by self-fulfilling perceptions. Commodity price changes reflect the relative pricing power of producers and consumers; exchange rates add nothing to the analysis.

But that is only true for relatively moderate changes in the dollar’s value against the euro, yen and other major traded currencies of the sort seen almost continuously for the past 20 years.

In contrast, a maxi-devaluation would lead to a re-pricing of oil and other commodity prices, redistributing real income and consumption away from the United States and Europe to households and firms in China. The United States and Europe are simply too large to devalue their way out of trouble without triggering big shifts in commodity prices.

By revaluing the output of China’s businesses and households, maxi-devaluation would also massively increase China’s “weight” in the global economy, accelerating the rapid shift in the centre of gravity in the world economy from the economies of the North Atlantic to East Asia.

Proponents of devaluation (and they are numerous) often portray it as a simple panacea. But maxi-devaluation would trigger a series of wrenching structural shifts in the advanced economies and globally. It might create more jobs in the United States, but all U.S. households would feel noticeably poorer as their real purchasing power is slashed.

It would ram home the fact that U.S. and even European households have been living far beyond their means — enjoying a high standard of living only because of an overvalued currency and the hard work for limited rewards common in China and many other parts of emerging Asia.

Exchange rate realignments are a necessary and inevitable part of the global adjustments that will be necessary in the next few years. In some ways they will make explicit the huge shift that has already been occurring for the past decade, but masked by China’s reserve accumulation and cheap credit in the western world.

But let’s not pretend they will be painless for households and businesses across the United States and Europe. Extra jobs and more exports will be purchased by lower real consumption. Living standards will fall, reflecting the reduced external value of U.S. and European output.


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