Revaluing the Yuan (and also the Yen)

From the department of realignment:

Finance ministers from the G7 group of leading industrial countries have called on China to allow its currency to rise in value more quickly.

This would make Chinese goods less competitive and could help curb China's international trade surplus.

The G7 said it could also help reduce inflationary pressures in China because it would make imports cheaper.

The deputy governor of China's central bank said it was committed to gradual revaluation alongside economic reform.

But, added Wu Xiaoling, "moving the exchange rates in the absence of economic restructuring policies will hurt China".

In a statement issued after a meeting in Washington, the G7 also said their own economies remained fundamentally strong but there was an acknowledgement that oil prices and the US housing market are potential problems.

I believe that one of the most fundamental principles of economics is balance. Economic imbalances include things like hefty current account deficits and government debt. However, imbalances can also be hefty current account surpluses and large government savings.

China has a massive current account surplus - nearly US$250 billion. What this means is that China sells more than it buys, and it invests more than it borrows. This sounds like a good thing but it's not. This is because for every dollar that China saves, someone else borrows it. Japan is in a similar situation with a current account surplus of nearly US$200 billion. Both China and Japan have hefty current account surpluses and that is not good.

The reason it is not good is because both China and Japan have helped create a situation in which the United States runs a hefty current account deficit - nearly US$800 billion. One nation's deficit (US) is another nation's surplus (China and Japan). In order for the world economy to be put on an even keel, these hefty deficits and surpluses need to be made neutral. In other words, both China and Japan need to save less and spend more, while the United States needs to save more and spend less.

At this present moment in time the United States is the world's biggest consumer. Although the US is also a producer, the economy is geared more towards consumption than production. China and Japan's economies are geared more towards production than consumption.

The world economy therefore needs the United States to consume less, and for China and Japan to consume more. This is more difficult than it sounds, though, since it needs a currency realignment - that is, the US Dollar needs to depreciate against the Yuan and the Yen.

It is not Congress or the President or even the Federal Reserve who determines the value of the US Dollar, but that amorphous thing called the "Marketplace". The Forex market essentially determines the value of the US Dollar against all other currencies. But while the US Dollar's value is not controlled by the US government, it is influenced very powerfully by the governments of China and Japan.

China's Yuan is a "pegged" currency, which means that its value is set by the Chinese government. The Chinese government, which has been steadily industrialising the country for the past 25 years, set the Yuan quite low in order to make Chinese industrial products cheap and competitive. To prevent black-market trading between the Yuan and the US Dollar, the Chinese government has essentially ensured that large amounts of money are invested back into the United States. To put it simply, China is lending America the money it needs to purchase Chinese goods.

The Japanese Yen is not pegged, but the Japanese central bank has been buying up billions in US government bonds for some time. The practice is essentially the same as China - Japan lends America the money it needs to buy Japanese goods.

The governments of Japan and China have essentially entered into the Forex market and are major influencers in how it is run. The continual purchase of US bonds by the governments of China and Japan has meant that the US Dollar is overvalued while the Yuan and the Yen are undervalued.

If China and Japan are to increase their consumption of goods and services, then both the Yuan and the Yen need to appreciate in value. The first thing that both countries need to do is to stop buying US bonds. The second thing that needs to be done is for China to unpeg its currency and let the Yuan's price be set by the Forex market.

Of course it would be remiss of me to point out that the United States is not guiltless in this process either. It has been government policy for some time to have a strong dollar and to gear the US economy towards consumption over and above production. This has resulted in a large current account deficit which has, eventually, led to a plunging US dollar. The US could've quite easily chosen to rebalance things out by buying up Yen or other currencies but they chose not to. Even basic actions like refusing to sell bonds to the Chinese and Japanese governments were not thought up.

The problem with this sort of realignment is that the move from imbalance to balance will require time to adjust. For Americans, it will require higher rates of saving and lower rates of consumption. For China and Japan it will require higher rates of consumption and lower rates of saving. Rebalancing a global economy - a process which is already underway with the plunging US Dollar - will produce pain long before it produces gain.