The real consequences for the international economy of an early increase in

the RMB's exchange rate

By John Ross

The RMB’s exchange rate is clearly an issue deserving the most precise economic analysis
given that it involves the world’s largest exporter, China, and the world’s largest economy,
the US. It might therefore seem surprising that a frequent feature of calls for early RMB
revaluation are attempts to justify this through what are in a quite literal sense economic 'non
sequiturs' - non-sequitur being Latin for ‘it does not follow’.

Such arguments consist of two sentences. ‘China runs a trade surplus. Therefore to eliminate
it China should increase the exchange rate of the RMB.’

Unfortunately elementary economic reflection will show that the second sentence does not
necessarily follow from the first. Consideration of supply and demand reminds us that an
increase in the exchange rate of the RMB will only reduce China’s export earnings if demand
for China’s exports is elastic – that is any percentage fall in sales is greater than any
percentage rise in price resulting from revaluation. Equally China’s imports in value terms
will only rise if any increase in their volume is greater than any fall in their price due to
revaluation.

The question of whether China's trade surplus will fall or rise in response to RMB revaluation
is therefore a matter of fact, not of logic, which therefore has to be examined empirically - as
the paper below notes. It quite simply does not follow that an increase in China’s exchange
rate will logically necessarily lead to a fall in China’s trade surplus. Indeed it is quite possible
logically, for example if demand for China’s exports is inelastic, and the volume of its
imports is not particularly price sensitive, that a rise in the RMB’s exchange rate will lead to
an increase in China’s trade surplus.

Given the seriousness of the issue one would have thought that if this matter were being dealt
with objectively the US administration would have produced a mountain of material to justify
its claim that an increase in the RMB’s exchange rate would lead to a fall in China’s trade
surplus - China has certainly produced abundant data, including directly by the Commerce
Minister, showing the opposite. But no such material has been forthcoming from the US
administration. Instead there is the intoning of a literal non-sequitur.

The reason evidence has not been produced by either the US administration or by those in
agreement with it is that at least as regards the immediate and medium term economic
situation their argument is factually false. As is shown in the paper below an increase in the
RMB’s exchange rate would immediately lead to an increase in China’s trade surplus and not
to a fall – and this is one of the last things which the world requires while attempting to
emerge from the international financial crisis.

This paper was written in April and published in Chinese. It deals with a wider range of
issues than simply bilateral China-US trade. The opening paragraph has been amended to
remove purely contemporary references and altered to read in the past tense. The rest of the
article is unchanged - its fundamental arguments do not require revising.

*   *   *
At the meeting between President Obama and President Hu Jintao earlier this year the
Chinese side noted that RMB appreciation would not balance Sino-U.S. trade. This
conclusion reiterated other studies published by Chinese ministers and economic specialists
on bilateral US-China trade. This conclusion is in line with the data below.

However it should also be noted that 84% of China’s foreign trade is with countries other
than the US. A change in the RMB’s exchange rate would therefore have not only bilateral
consequences between the US and China but wider effects on the world economy. This
article therefore examines these. The most important conclusion it demonstrates is that: 

 The immediate effect of an increase in the RMB’s exchange rate would be to increase
China’s trade surplus and not decrease it – contrary to apparent expectations of the US
administration;

It is important to understand this dynamic so that wrong anticipations of events do not exist in
the US, China or elsewhere.

In addition: 

 RMB revaluation would produce limited but distinct inflationary pressure not only in
the US but in the international economy due to China’s position as the world’s largest
exporter; 
 As 84% of China’s trade is with countries other than the US the consequences for the
rest of the world economy of early RMB revaluation would be greater than for the
US. 
 At present China is in trade balance or deficit with the rest of the world apart from the
US – limiting trade frictions to a relatively few countries. RMB revaluation would
probably shift China to running a trade surplus with the rest of the world apart from
the US, widening the range of countries with which trade frictions are possible.

While Chinese economic policy makers may have valid overriding domestic reasons for an
early increase in the RMB’s exchange rate, such as the struggle against inflation or to aid
cooling the economy, this will not resolve trade issues. Indeed it should be recognised that in
the field of trade there is a significant risk of negative trends created by an RMB revaluation
which must be taken into consideration.

The aim of this paper is, therefore, to clarify factual understanding of what would actually
occur if an increase in the RMB’s exchange rate occurred.

The empirical evidence on the consequences of an increase in the RMB’s exchange rate

The argument of those favouring an early increase in the exchange rate of the RMB is that as
China runs a trade surplus it should revalue the RMB to reduce it. Unfortunately the second
part of the argument only follows from the first if factually RMB revaluation would lead to a
reduction in China’s surplus. This is an issue of economic fact - of the degree of the elasticity
of demand for China’s exports and imports and of their independence of movement - and it
does not follow as a matter of logic. Furthermore it is necessary to distinguish between
effects in the short term and the long term.
If for example, other things remaining equal, over any given period of time the RMB’s
exchange rate went up 10% but China’s export volume fell by only 5% then China’s trade
surplus would actually increase due to RMB revaluation. For China’s trade surplus to fall
after revaluation changes in the volume of China’s exports and imports would have to be
sufficient to offset the fact that RMB revaluation will produce an increase in China’s export
prices relative to import prices.

Most of those arguing for short term RMB revaluation make no attempt to demonstrate this
factual linkage - they illegitimately claim it without proof. The reason they do not attempt to
prove it is that particularly in the short term, which is crucial for the world as it emerges from
the financial crisis, it is false.

The consequences of RMB revaluation

Factually, as a number of Chinese authors have pointed out, over the short to medium term it
is unnecessary to rely purely on theoretical models to examine the consequences of an
increase in the RMB’s exchange rate on bilateral trade with the US. As they note, the increase
in RMB’s exchange rate from July 2005 to August 2008 led not to a decrease of China’s
bilateral trade surplus with the US but to its increase. However this trend of China’s trade
surplus increasing as the RMB’s exchange rate rose was general and not simply a bilateral
one with the US.

Taking US figures for its own trade and the IMF’s for total trade, to avoid any suggestion of
relying on China’s data which might be alleged to be biased, and to remove secondary
differences on the calculation of bilateral US-China trade balances, the US trade deficit with
China increased from $162 billion in 2004, the year before RMB revaluation, to $268 billion
in 2008 – a rise of $106 billion or 65%. However over the same period China’s trade balance
with the rest of the world moved from a deficit of $103 billion to a surplus of $93 billion – a
movement of $196 billion in China’s favour. The factual evidence over a three year period
therefore showed that an increase in the RMB’s exchange rate led to an increase in China’s
trade surplus, and not to a decline, not only with the US but with the rest of the world
economy.

This trend is shown clearly in Figure 1 - which graphs the way in which the increase in
China’s exchange rate was accompanied not by a fall in China’s trade surplus but by an
increase.
 Figure 1

The trade surplus was due to a fall in the relative value of China’s imports

The explanation of why China’s trade surplus increased as the RMB’s exchange rate rose is
clarified by Figure 2 - which shows China’s exports and imports as a percentage of GDP. As
may be seen, prior to 2004, during the period of RMB exchange rate stability, China’s
exports and imports rose in parallel as a percentage of GDP. Consequently no trade surplus
developed.

From 2005 onwards, however, China’s exports continued to rise as a percentage of GDP but
its imports began to fall. Factually, therefore, the emergence of China’s trade surplus was not
due to acceleration of exports, as is frequently claimed, but to a relative fall in the value of
China’s imports.

To judge from their statements US commentators, and others, advocating an early increase in
the RMBs exchange rate do not appear to have studied this factual trend.
 Figure 2

Why an increase in the RMB’s exchange rate led to an increase in China’s trade surplus

There is a clear economic explanation of the factual trends shown above – i.e. that as long as
the RMB’s exchange rate remained stable exports and imports moved in parallel in value
terms, and no trade surplus developed, but when as an increase in the exchange rate took
place the total value of imports fell relative to the total value of exports and therefore a trade
surplus develop. This trend would necessarily be the case if China’s exports and imports
moved together in volume terms, or if the effects of the shifts in relative volumes were lower
than the effects of the shifts in relative prices. In that case the effect of RMB revaluation
would put up China’s export prices relative to its import prices, the changes in export and
import volumes would be less that the effect of the rise in export prices relative to import
prices, and therefore an increase in the RMB’s exchange rate would increase the trade
surplus. The explanation of this tendency of exports and imports to relatively move together
in volume terms would be if a large proportion of imports were inputs into exports – as is the
case with China.

That this is the explanation of why the increase in the RMBs exchange rate after 2004 led to
an increase in China’s trade surplus, and not to its reduction, is indicated in Figure 3, which
shows the UN’s calculations for the movement of China’s exports and imports in fixed price,
i.e. volume, terms from 1998-2008. As may be seen the volume of China’s exports and
imports moved essentially in parallel throughout this period. Under those circumstances an
increase in the RMB’s exchange rate would necessarily lead to an expansion of China’s trade
surplus – as occurred.
 Figure 3

The ‘J curve’ effect

To analyse the effect of RMB revaluation over an even shorter time frame, it will be
assumed, simply for the sake of argument, that the long term effect of an increase in the
RMB’s exchange rate would gradually break down the tendency of the volume of China’s
exports and imports to move relatively in parallel – although, it may be noted that after July
2005 this did not occur over a three year period, and under conditions of a 21% revaluation,
and therefore a considerable delay in adjustment should be anticipated. However even in this
case the short term effect on an RMB revaluation would be to increase China’s trade surplus.

The reason for this is the well established short-term ‘J curve’ effect regarding currency
exchange rate changes. Under this effect, when a currency’s exchange rate changes, it takes
time for demand to adjust. Therefore in the short term, whatever the long term shifts, the
change in volumes relative to the effect of price shifts is relatively weak. Revaluation
increases export prices and reduces import prices. The ‘J curve effect’ of an RMB revaluation
would increase China’s trade surplus in the short term.

However even a short term increase in China’s trade surplus would reverse the most
significant present source of international demand and be negative for the world economy as
it attempts to emerge from the financial crisis.

It may be noted that purely modelling studies on the long term effects of an increase in the
RMB’s exchange rate on China’s trade surplus are mixed. Some find that it would lead to a
fall in China’s trade surplus and some that it would lead to an increase. The empirical
evidence of a three year rise with a 21% revaluation after 2005 is, however, that it led to an
increase in China’s trade surplus and not a fall.

Unless the evidently implausible assumption is made that China’s economy can remain
competitive no matter how high its exchange rate, at some point in a very rapid and very
large revaluation the trend seen in 2005-2008 would be reversed, and a rising RMB exchange
rate would lead to a fall in China’s trade surplus. However the empirical evidence is that such
an increase in the RMB’s exchange rate would have to be of a very high percentage and of
exceptional duration to reduce China’s trade deficit. Such a very sharp and very prolonged
increase in the RMB’s exchange rate would, of course, do great damage to China’s economy
and under such circumstances China’s trade surplus would only decline after it had continued
to increase for possibly a significant period.

On any reasonable assumptions, therefore, the short and probably medium term consequences
of an increase in the RMB’s exchange rate would be to increase China’s trade surplus and not
reduce it.

The structure of China’s trade

Turning from the direction of change that would be produced in the short to intermediate
term of an increase in the RMB’s exchange rate to its consequences, a picture is frequently
presented by critics of China’s exchange rate policy which creates the impression that China
runs a massive trade surplus with virtually the entire world. It is important to understand that
the factual situation is the opposite. The trade data produced by the US itself shows that
China’s trade has frequently been in deficit with the rest of the world apart from the US, that
the surplus in China’s non-US trade which did appear after 2006 is declining rapidly, and that
China has almost certainly returned to a situation where its trade with the rest of the world,
apart from the US, is once again in balance or in deficit.

It should be again made clear that this situation is clear from US data and does not require
acceptance of China’s own data or resolution of the statistical differences between US and
China. In the following IMF figures are used for China’s total trade.

China’s trade is in deficit with the rest of the world excluding the US

To understand a difference between widely cited US and Chinese trade figures It should be
noted that the most frequently quoted US trade statistics differ from the trade data usually
quoted in China in that they exclude indirect trade costs such as transport, insurance etc. – i.e.
US data is usually cited on a balance of payments basis whereas China’s statistics are usually
cited on a balance of trade basis. Calculated on the US basis Figure 4 shows China’s total
trade balance, its trade balance with the US, and China’s balance on non-US trade.

The pattern of China’s trade with the rest of the world, apart from the US, is evident. Until
2006 China ran a deficit on non-US trade. In 2007 and 2008 a surplus appeared - of $57
billion and $93 billion respectively, and in 2009 this again fell to around $15 billion. As
China’s trade surplus has continued to fall in 2010 it is almost certain that China’s trade is
now once again in balance or deficit with the rest of the world apart from the US.
 Figure 4

The geographical distribution of China’s trade

Turning to the more specific geographical structure of China’s trade, US statistics indicate
that 76% of China’s exports went to countries other than the US – China’s trade figures show
83% of its exports going to non-US destinations. Calculated from US figures, 94% of China’s
imports come from countries other than the US – approximately the same figure as in China’s
trade data. In total, even on US figures, 84% of China’s trade is with countries other than the
US.

An immediate consequence of the US argument on RMB revaluation is evident from this

geographical distribution of China’s trade. The US is proposing to address a bilateral issue,
that of the US-China trade balance, with a solution, an increase in the RMB’s exchange rate,
which would affect not only the US but all countries. Indeed by far the greatest part of the
direct impact of an increase in the RMB’s exchange rate, that is 84% of it, would be outside
the US while only 16% would be on trade with the US.

It may also be noted from the graph above that the effect of the increase in the exchange rate
of the RMB on China’s balance on non-US trade was much greater than its effect on trade
with the US. Between 2004, the year before RMB revaluation commenced, and 2008 the
increase of China’s trade surplus with the US was $106 billion. The shift in China’s favour in
the balance of non-US trade was however $196 billion – from a deficit of $93 billion to a
surplus of $103 billion. This indicates a danger that the short/intermediate term increase in
China’s trade balance with countries other than the US which would result from an increase
in the RMB’s exchange rate would be great than with the US – creating a potential for
widening of trade frictions.

International impact of RMB revaluation

Analysing this quantitative structure of China’s trade, the general effect of an increase in the
RMB’s exchange rate on inflation and living standards in other countries may be gauged.
RMB revaluation, other things remaining equal, puts up China’s export prices. While the
indirect inflationary impacts of such export price increases are difficult to calculate, as they
tend to be self-reinforcing, the approximate magnitude of the direct inflationary effect of an
increase in RMB prices due to revaluation is evident from this data.

A number of China’s commentators have pointed out that an increase in China’s export prices
would reduce living standards and add to inflationary pressure in the US. To put figures on
the scale of this effect, China’s exports to the US in 2007-2009 were slightly above 2% of US
GDP in each year ($321 billion in 2007, $337 billion in 2008, and $296 billion in 2007). A
rough guide to the direct inflationary effects, other things being equal, is therefore that a 10%
increase in the RMB’s exchange rate would add 0.2% to US inflation, a 20% revaluation of
the RMB would add 0.4% to US inflation etc. Other factors remaining equal, this would
translate into a reduction of the same order of magnitude in US living standards. Given that
China’s imports are largely in the lower part of the price spectrum, the effect on the least well
off US consumers would be greatest.

However due to the relatively low percentage of trade in US GDP the inflationary impact, or
put in other terms the effect in lowering living standards, on the rest of the world of an RMB
revaluation rate would actually be somewhat greater than for the US.

Assuming China’s exports are priced in dollars, as in the majority of cases, in 2008, the latest
year for which full figures are available, China’s merchandise exports to non-US destinations
were equivalent to 2.6% of the world’s GDP excluding the US and China. Other things being
equal, therefore, the direct effects of a 10% increase in the RMB’s exchange rate would add
approximately 0.26% to world inflation, a 20% increase in the RMB exchange rate would add
0.52% to world inflation etc. A 40% increase in the RMB’s exchange rate, as demanded by
some in the US, would add in terms of direct effect more than 1% to world inflation. Other
factors remaining equal, there would be equivalent reductions in world living standards.

Naturally, given the complex interactions involved in determining inflation and consequent
reductions in living standards, these figures on direct effects only give guides to orders of
magnitude. But they are sufficient to confirm that the greater part of the effect of any increase
in the exchange rate of the RMB would be felt outside the US – inevitably given the
geographical distribution of China’s trade. China’s position as the world’s largest exporter
means that changes in its exchange rate have a perceptible effect on international inflation
and living standards.

It is superfluous to note that such pressures to inflation and reduction in living standards are
undesirable – particularly in conditions where the world is recovering from the worst
financial crisis for eighty years.

Short term consequences of RMB revaluation

Turning from such structural effects to more short term consequences the latter might be
roughly defined as covering a 6-18 month period. Normally it might be possible to ignore
such short term effects, but this cannot be done under conditions where the world economy is
still recovering from severe financial meltdown.

To evaluate short term consequences it is necessary to recall that China is not only the
world’s largest exporter but also its fastest growing importer. Since the outbreak of the
international financial crisis, China’s imports have provided the world’s single biggest boost
in external demand for other economies.

In annualised terms between July 2008 and December 2009 OECD data shows US imports
fell by $550 billion and China’s imports rose by $100 billion, while in the same period the
US trade deficit shrank by $364 billion and China’s surplus fell by $180 billion. On an
annualised basis the US therefore was subtracting $364 billion from international net demand
while China was adding $180 billion.

Since more than half the goods China imports are inputs to exports, a cut in the volume of
China’s exports, due to RMB revaluation, would lead to reductions in its imports – evidently
hitting countries such as Japan, South Korea, Germany and Australia especially hard.

Furthermore the US explicitly aims to reduce its trade deficit – thereby reducing net
international demand. China’s policy is to expand international demand by boosting imports
and cutting its trade surplus. A reversal of the trend whereby China’s trade surplus was
falling, which would be caused by RMB revaluation, would therefore have an undesirable
effect in reducing world external demand.

Growth of imports and domestic economic policy

Finally, as RMB appreciation, that is a movement in the relative price of exports and imports,
would for the reasons outlined lead to an immediate increase in China’s trade surplus,
therefore, what means are available to reduce the trade surplus? As this cannot be achieved in
the short to intermediate term by price changes the answer necessarily has to be found in
effects on volumes. Given that reduction in exports is undesirable, as China’s export
industries have still not recovered their previous volumes of output prior to the financial
crisis, the only workable solution to narrowing China’s trade gap further, as Commerce
Ministry spokesperson, Yao Jian stated, is to take "measures to stimulate imports."

This of course occurred during 2009 and 2010 and narrowed China’s trade surplus. The pre-
financial crisis peak of China’s exports and imports was reached in July 2008. By March
2010, compared to the pre-crisis peak level, China’s exports had fallen by 18% but its
imports had risen by 7%.

Stimulating imports, however, is not primarily a matter of trade delegations – although these
are of course useful. It is primarily a function, first, of measures to stimulate domestic
demand and second of the rapid growth of China’s economy.

China's imports rose faster than exports in 2009 in major part because its economy grew more
rapidly than others. While other markets stagnated or declined, China grew at 8.7 percent,
and sucked in imports. The most effective way to maintain the import surge is rapid
economic growth.

Inflation and domestic economic policy

At this point trade intersects with domestic economic policy. The most immediate threat to
growth in China is inflation. Inflationary capacity constraints have already emerged.
Fortunately China's 2009 growth pattern puts it in better shape to deal with inflation than if it
had followed some of the advice it was offered from abroad. Many commentators who called
for revaluation also favoured expanding domestic consumption, but not investment – citing
the threat of "overcapacity". If this policy had been pursued, China would be facing much
greater inflationary capacity constraints – threatening economic growth and imports. Happily,
China expanded both domestic consumption and investment. The increased capacity that
resulted will allow faster growth than would otherwise have been the case, increasing demand
for imports.

Mutually beneficial policies

A coherent strategy both from China's point of view and for creating a "win-win" situation
with other economies therefore means avoiding an excessively early RMB revaluation. This
will allow China's exporters to recover and avoid a short term increase in China's trade
surplus. Simultaneously rapid economic growth is not just good for China but also boosts
imports. And to make rapid growth possible without inflation China needs to boost domestic
investment as well as consumption. Investment, in turn, boosts imports of machinery and
equipment. Foreign countries should argue for China to maintain the existing RMB exchange
rate in the short run, maintain rapid growth, and, to underpin growth, undertake high levels of
domestic investment. This is the combination that will create a "win-win" situation. By
contrast, an excessively early RMB revaluation would create a "lose-lose" scenario. It would
hit China's exporters, lead to a short term increase in China's trade surplus, withdraw an
economic stimulus in a recessionary international economic situation and, linked to reducing
investment, would exacerbate inflationary capacity constraints. It may be that other economic
considerations, notably the fight against inflation, will force China into a premature increase
in the RMB's exchange rate, but from the trade point of view, and that of international
economic recovery, this would be undesirable.

Conclusion

Holding the RMB’s exchange rate steady in the short term, while letting it rise in the
medium/long term, has so far been the position of China’s government. This seems to have
been based primarily on domestic economic considerations. But it also happened to be in the
best interests of the world economy.

It may be noted that, of course, trade cannot be the only consideration in setting the RMB’s
exchange rate. RMB revaluation may be adopted for reasons such as the struggle against
inflation or cooling an overheated economy. These considerations may have to take priority
over trade policy. However such decisions should be taken recognising that, in the short term,
RMB revaluation will put upward pressure on China’s trade surplus.

Timing

Timing is crucial for the world economy and therefore for RMB revaluation. In the medium
to long term evidently the exchange rate of the RMB should and will go up – the increasing
productivity of China’s economy makes it competitive at progressively higher exchange
rates. But because an increase in the RMB exchange rate would put upward pressure on
China’s trade surplus in the short term, from the point of view of world trade it would be
better if revaluation did not take place until the world recovery is more firmly established –
on current trends likely to be closer to the end of this year.
Appendix – a note on some false arguments by foreign critics of China’s exchange rate
policy

In the paper above a number of serious arguments relating to RMB revaluation have been
dealt with. It should, however, be noted that a number of simply false claims regarding
China’s trade are made by international critics. Two of these, notably that by the influential
US economist Paul Krugman, who called for US trade action against China in a New York
Times column which has been widely quoted, are therefore dealt with here.

Paul Krugman’s erroneous claim

It was analysed above that China’s trade with the rest of the world, apart from the US, has
frequently been in deficit and has probably passed back into balance or deficit in 2010. It may
be noted from this reality why some critics make false and exaggerated claims regarding the
size of the China’s surplus – a statement of the actual facts would reveal the actual situation
that China has not typically, and is not currently, running a surplus in non-US trade. For
example Paul Krugman, talking about China’s balance of payments, including service and
investment income as well as trade, in his New York Times column claimed that ‘the
International Monetary Fund expects China to have a 2010 current surplus of more than $450
billion.’

Of course if China were factually running a $450 billion dollar balance of payments surplus
this is sufficiently large it would entail that a trade surplus was being run not only with the
US but with the rest of the world. No source is given but if any IMF statistician made such a
claim it is inaccurate – as Krugman could have found out by checking the figures.

Once China’s balance on services and income is included, and the standard statistical
correction for carriage and insurance made, China’s annual balance of payments surplus is
about $120 billion over its unadjusted trade surplus. The latter was $198 billion in 2009 and
falling – in the 12 months to February 2010 it was $180 billion. Therefore there is no way
China’s balance of payment surplus will reach anything like $450 billion this year. The actual
falling trend of China’s trade surplus is shown in Figure 5.
 Figure 5

To take a similar example, the British economist Will Hutton claimed in The Observer that
China is ‘increasing its reliance on exports.’ Again this is factually false. China’s exports
declined to 25 percent of GDP in 2009 from 35.7 percent in 2006 – as shown in Figure 2. In
reality the increase in China’s domestic demand has led to a sharp decline in the weight of
exports in China’s GDP.

Figure 6
 * * *

This article originally appeared on the blog Key Trends in Globalisation on 15 June 2010.