China Can't Solve the U.S. Dollar's Problems

• A revaluation of China's currency is unlikely to solve the problem of global imbalances.
• China's households and firms have rational reasons for the high precautionary saving that props up the yuan.
• Global diversification away from the dollar will continue until the U.S. confronts its own fiscal problems.

A weaker dollar has not brought a decline in the bilateral deficit between the U.S. and China. This is a key source of tension between Washington and Beijing. The yuan's effective peg to the dollar has predictably fueled resentment among U.S. exporters. While the U.S. does not officially claim that China manipulates its currency, officials continue to imply that China should revalue the yuan higher.

Yet the dollar's depreciation has more to do with the excess liquidity sloshing around the global economy and diversification away from dollar-denominated assets by central banks than it does with China's yuan policy. Investor expectations about the future path of U.S. monetary and fiscal policy are driving the greenback's depreciation in a far greater way than the lack of flexibility in the yuan. While domestic political considerations may encourage officials to blame the yuan for some current economic woes, this is counterproductive and will not erase the bilateral trade deficit between the U.S. and China.

Revaluation and the trade deficit

A common refrain among economists and policymakers is that for global economic imbalances to be addressed, China must revalue its currency. Many believe the yuan needs to be revalued by as much as 25% against the dollar. However, an empirical look at the relationship between dollar-yuan exchange rates and the bilateral deficit does not support that claim.

Since July 2005, the yuan has increased in value against the dollar by 21% on a nominal basis. On a real effective basis, the yuan's dollar value has risen 15%. More importantly, from 2005 to just before the peak of the recent financial crisis, the bilateral trade deficit between the U.S. and China increased 30%. Since the onset of the crisis, the Chinese have moved away from a managed-float policy, in which the yuan was allowed to rise gradually against the dollar, to an effective peg; this has exacerbated trade tensions between China and other Asian nations, as well as with the U.S.

With demand for imports falling globally amid disruptions in trade finance and a worldwide recession, the U.S.-China trade deficit still grew, though at a slower 5% rate over that same period. As the U.S. economy recovers, the bilateral trade deficit may accelerate once again.

Current conventional wisdom about how to address global imbalances echoes ideas of the 1980s, when Japan was pressured to revalue its currency, only to face devaluation of its dollar-denominated assets. The Chinese repeatedly point to that case and caution other nations not to expect revaluation of the yuan soon.

Precautionary savings

A change in relative prices can stimulate changes in behavior. A weaker dollar should cause U.S. goods and services to become more attractive to Chinese consumers, who benefit from increased purchasing power. If so, why has the bilateral deficit increased since 2005?

Chinese consumers save a far higher percentage of their incomes and spend far less than do their U.S. counterparts. This is entirely rational given China's relative lack of basic healthcare, pensions, unemployment insurance or public education. On average, Chinese households save nearly 20% of their incomes. The overall national saving rate is close to 30%, with domestic corporations saving even more than households. This suggests that a revalued yuan will not solve the dollar's problems nor end global economic imbalances. Major structural changes must occur inside China before individual consumption increases to levels consistent with the size of the Chinese economy.

Moreover, the yuan is not yet ready to play a greater role in the global economy. The U.S. dollar may eventually lose its place as the primary global reserve currency, but there is not yet an heir apparent. The yuan is not convertible and domestic Chinese capital markets do not have the breadth or depth to support a completely flexible yuan. Chinese multinational firms, for the most part, still have to hedge against volatility in currency markets by using offshore platforms. Although China has taken tentative steps to arrange currency swaps with select emerging markets to facilitate trade, the government will not soon be ready to take the next step and move to convertibility.

Diversifying away from the dollar

In response to the global financial crisis, G-20 members with large external deficits have moved to stimulate private savings and shrink fiscal deficits. Those with significant surpluses have pledged to strengthen domestic sources of growth. Both surplus and deficit nations have pledged to do so within the framework of open and transparent markets. The surest cure for a long-term secular decline in the dollar would be a sustainable U.S. fiscal trajectory and a transparent commitment to reduced federal budget deficits.

The U.S. fiscal deficit is on track to reach 10% of GDP in 2009. Ambitious spending plans on healthcare and the environment, without increased taxes to pay for them, will cause annual federal deficits to soar further. A clear commitment to increase taxes and reduce future outlays could provide a clear anchor against the dollar's current drift and facilitate an orderly rebalancing of the global economy. But such changes will be challenging given U.S. domestic political realities.

Those political difficulties and uncertainty that the U.S. can tame federal spending are driving global central banks to diversify their holdings away from the dollar, toward other global currencies such as euros and yen. At the end of the second quarter of 2009, the dollar's average share of new global reserves had fallen to 37% from 56% in 2000, a trend that likely accelerated with the greenback's recent deprecation.

The U.S. economy has begun a structural adjustment that will stretch over years. Aggressive steps by the Obama administration and the Federal Reserve to prevent a second Great Depression were necessary. But those steps are not without cost. The U.S. dollar will likely weaken over time against other major currencies. Global central banks will act in their own interests and continue to diversify away from the dollar. To ensure this process does not become a disorderly rout for the dollar, it is imperative that the U.S. get its fiscal house in order. The time of lecturing to those who finance our debt to alter their economic policies to suit our own ends has passed.