VoxEU Column Exchange Rates

The China syndrome on exchange rates

China’s exchange rate policy has implications for global trade and particularly other East Asian nations. This column argues that, given China’s fixation on the dollar peg, countries such as Thailand and Malaysia may have no choice but to peg their currencies to China’s yuan.

There is no need to belabour the point that flexible prices play a key role in correcting imbalances, be they between supply and demand for products, or between saving and investment or, for that matter, global imbalances of international capital or trade flows. This is simply the magic of the price mechanism in textbooks.

But in the real world prices are not that flexible – for a variety of reasons. Not least among them policy preferences to keep prices at certain levels, targeted at given policy objectives. Thanks to subsidies or protectionist measures, it is not uncommon to see deliberately underpriced or overpriced products.

Likewise, interest rates are usually manipulated by monetary authorities with the intention of influencing not only savings and investment, but also output, employment and inflation.

Similarly, exchange rates are often controlled by central banks, with flexibilities ranging from free floats to fixed rates.

All this affects the much-needed rebalancing of the global economy. There is near-consensus that the current global economic illness is primarily due to deep-seated global imbalances between production and consumption, savings and investment, and imports and exports of goods and services.

Such imbalances will have to be reduced, if not eliminated. Policy actions that fail to address these critical issues are tantamount to treating the symptoms, such as output loss and unemployment, but not the disease.

Rebalancing warrants both expenditure and price adjustments. Exchange-rate adjustments are among the latter. It is disappointing that the crisis that hit the global economy in mid-2008, with its epicentre in the US, has led to few self-corrections in the balance-of-payments current account.

The US current account deficit has shrunk only marginally from 6% of GDP, while East Asian economies continue to register persistent balance-of-payments surpluses despite falling exports, and accumulate foreign exchange reserves.

For automatic adjustment mechanisms to work effectively, the crisis may have to last longer, in which case there will be considerable pain. Nor is there any suggestion that imbalances should be eliminated completely. All that we might reasonably wish to see is the current account deficit reduced to sustainable levels, which has not happened. The US current account deficit still exceeds 5% of GDP, way above the sustainable level estimated at 3% of GDP.

Exchange rate policies standing in the way

What is standing in the way has been the absence of realistic exchange rates in the foreign exchange market in recent times. The exchange rates of some major currencies vis-à-vis the dollar have been either rigid or moving in the wrong direction. A weaker greenback would help the faltering US economy by stimulating US output for both exports and domestic consumption, but the dollar has not depreciated sufficiently to reflect the fundamentals.

The dollar is overvalued, arguably by 15 to 20%. The problem is that the dollar cannot depreciate unless other major currencies are allowed to appreciate. Thus far, the impact of dollar adjustments has been mainly on the euro and yen. Southeast Asian currencies, including the Indonesian rupiah, Thai baht, Singapore dollar and Malaysian ringgit, have also appreciated against the greenback.

The scope for further appreciation of these currencies – and by extension further depreciation of the US dollar – is very limited, as currency appreciation tends to hurt economies by rendering their exports uncompetitive. The US dollar can depreciate, as it must, only if some other key currencies appreciate.

The dark horse in the currency matrix is the Chinese yuan, which has not budged in recent times. The yuan did appreciate by roughly 20% after China moved off the dollar-peg regime in favour of a basket peg regime in 2005, but the yuan was de facto re-pegged to the US dollar three years later by assigning nearly 100% weight to the US currency in the so-called currency basket.

Since then, the yuan has depreciated with the dollar. Herein lies the anomaly, in which an undervalued yuan is shackled to an overvalued dollar, making it absolutely unsustainable.

Be this as it may, China may have its own reasons for keeping its yuan tied to the dollar. For one thing, this would help increase China’s export market share, especially in the US, by rendering its exports competitive. For another, it would protect China’s vast foreign exchange reserves, which are largely dollar-denominated.

While this may make considerable sense to China, it does not go down well with its neighbours whose currencies have been appreciating against the yuan. Nor does it go down well in the US, whose currency would depreciate only if China is willing to share the burden of currency adjustments with the Eurozone and Japan by allowing its own currency to appreciate.

The chances of China revaluing its yuan look slim in the near term, given its huge stake in the US market as an exporter of manufactures and its vast exposure to the US as a creditor. China will not make the mistake Japan made in 1985 in accepting the Plaza Accord, which led to a soaring yen, from which Japan has yet to recover. International pressure is therefore unlikely to work insofar as China’s yuan is concerned.

This means that global rebalancing, in balance-of-payments terms, hinges critically on China’s exchange rate policy. There is hope that China might be persuaded by its neighbours, in the name of East Asian economic regionalism, to let its currency appreciate gradually. If not, it is almost certain that China will eat into the market share of its neighbours, whose currencies would appreciate against the dollar and the yuan.

The yuan will appreciate only if the dollar does. But a strong dollar is not in the interest of the US economy or global rebalancing. Given this conundrum, countries such as Thailand and Malaysia may have no choice but to peg their currencies to China’s yuan so they are not disadvantaged by China’s exchange rate policy. As the old adage goes, “if you can’t beat them, join them”.

Editor’s note: This piece is reposted from www.EastAsiaForum.org and was first in print in the New Straits Times.


Ariff, Mohamed (2010), “Cause for caution amid global imbalances”, eastasiaforum.org, 15 January.

Corden, Max (2009), “China’s exchange rate policy, its current account surplus, and the global imbalances”, eastasiaforum.org, 2 December.

Huang, Yiping (2009), “China’s exchange rate policy dilemma”, eastasiaforum.org, 22 February.

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