The Chinese RMB: Its Value, Its Peg, and Its Future

The valuation of the Chinese renminbi (RMB) has drawn lots of attention lately. The IMF, the U.S. government, and the G-7 finance ministers are urging China to revalue its currency, which is currently pegged at 8.28 to the dollar. The arguments for China to appreciate its currency roughly follow these lines:

* China's currency is grossly undervalued;

* the undervalued RMB is attracting a flood of hot money into China, complicating the authorities' efforts to engineer a soft-landing for an overheated economy; and

* the RMB's undervaluation and its peg to the dollar are preventing other Asian countries from allowing currencies to rise against the dollar, since appreciation would damage competiveness relative to China.

This last point is of particular concern because, it is argued, U.S. external imbalances cannot be addressed in the face of China's and other Asian nations' historically unprecedented accumulations of U.S. dollar reserves in recent years.

There have been many studies on the RMB's valuation with inconclusive, contradictory results (see, e.g., Wang, 2004). To address that difficult valuation question, this paper develops a new absolute PPP index that measures China's PPP against the United States and other countries. The new index shows the RMB to be substantially undervalued in the context of "conventional wisdom." However, the undervaluation is not unusual, given China's level of economic development; and conventional wisdom does not apply to China, because by any measure it is an undeveloped nation for which a currency peg is useful to maintain domestic economic and political stability (Prasad et al., 2003). In terms of multilateral external balances, we find it hard to argue that China's currency is contributing much to its trade and balance of payment surpluses, especially if one takes the 1997 perspective when the RMB was under tremendous depreciation pressure. Indeed, there is clear evidence that if China's trade balance was evenly distributed among its trading partners, there would be hardly any pressure for China to appreciate its currency. Thus, the pressure is political and structural in nature, originating from the large and growing multilateral trade imbalance of the United States. Unfortunately, it is much easier to blame China than to attack the underlying structural causes of the U.S. trade deficit. We conclude that the political pressure on China to abandon the RMB's peg to the dollar is likely to persist, and-as the most important growth market in the world today-China is more likely to move sooner rather than later to demonstrate that, in spite of the risks to its fragile financial system, it will share its global responsibilities as it eventually joins the G-7. The paper wraps up by placing the exchange issue in the broader context and discussing the longer-term prospects of the RMB.

Is the RMB Undervalued?

The RMB is undervalued in the conventional sense that there is too much demand for it relative to the supply. Fundamentally, demand for foreign currency comes from three sources:

* to buy goods or services,

* to invest in physical or financial assets, and

* to speculate on moves of the exchange rate itself.

With a closed capital account, China's currency is largely, but not entirely, immune from currency speculators and short-term portfolio investors. Recent studies at the China National Economic Research Institute (2003) indicate that much of the so-called "hot money" inflows are not a result of foreign hedge fund activities. Rather, they are a change in borrowing and deposit behaviors of domestic firms and individuals, taking advantage of the loopholes in the current foreign exchange regulations. Thus, we can focus our attention on the trade and long-term investment flows in China and look at the standard measures, such as purchasing power parity (PPP), trade balance, current account balance, balance of payments, and foreign reserves.

PPP is an ancient economic concept, dating back at least to David Hume (1752), which has been experiencing something of a revival lately.1 The Economist (current) defines PPP as "the exchange rate that equates the price of a basket of identical traded goods and services in two countries." The theory is that PPP exchange rates represent the equilibrium levels among the nations and that any departure from these levels causes potentially significant and distorting trade imbalances. There are different measures of PPP: a strong version or "absolute" version that emphasizes the absolute equality of prices (sometimes called "the Law of One Price") and a "relative" version that emphasizes the ongoing movement over time towards that equality.2

Unfortunately, the cross-country price data necessary to test these theories are hard to come by. The World Bank spends several millions of dollars on the International Comparison Program (ICP) to collect price data for various countries as an extension of the famous Penn World Table (World Bank, 2003; Kravis et al, 1975). The ICP data are comprehensive and the collection process is very rigorous, but it comes in slowly and does not include China! Instead, in its latest survey of 2003 global GDP by PPP, the World Bank relies on a 1995 study that suggests the RMB is undervalued by 78 percent (Ruoen and Chen, 1995). On the other hand, we have the famous, tongue-in-cheek Big Mac index by the Economist magazine.3 It's easily accessible, frequently updated, and as the Economist describes it, fun. Dozens of academic papers and a book (Ong, 2003) have been published using the Big Mac price data, which suggests that the Chinese RMB has been undervalued by 56 percent recently.

McDonald's tries very hard to make its Big Mac taste the same all over the world, but the problem with the Big Mac index is that it is a cheap "junk" food in the United States and other rich countries and a luxury treat for the vast majority of Chinese consumers. The differences in the Big Mac price could reflect the pricing-to-market effect rather than currency valuation (Pakko and Pollard, 2003). To fill a data void, we went to the other end of the basket spectrum and developed a price index called "Shef" (which stands for Salt, Haircut, Electricity, and Flour) that better reflects a developing country's perspective. The index follows the principle of the traditional Chinese measure of cost of living for the masses, which include four items: firewood, rice, cooking oil, and salt. In the Shef index, firewood is replaced by electricity and rice by wheat flour to make it more relevant for today's China as well as a wide range of countries. Unlike the Big Mac, which has at least seven commodity components, the items we selected (salt, electricity, and wheat flour) are perhaps as "pure commodities" as they can be. We also replaced cooking oil with a basic man's haircut to represent a pure service in the necessity category whose productivity has been largely immune from technological changes. Salt and flour represent a minimal share of consumer spending in rich countries, but they are standard items and necessities for the poor. We have collected Shef data for 27 major countries, which represent more than 85 percent of global GDP and 90 percent of global vehicle sales.

Table 1 shows the Shef data for the United States and China. The results are not surprising. Using the current exchange rate, salt and flour are 80 percent cheaper in China, while for the price of one haircut in the United States, you can have ten in China. Electricity prices are not so cheap in China, relatively speaking. If we treat these four items with equal weight, the Shef index seems to suggest that the RMB is 79 percent undervalued against the dollar, almost exactly the same as the World Bank's PPP measure but substantially greater than the Big Mac index. How is China's undervaluation compared with other countries? Figure 1 shows the Shef index plotted against GDP per capita for 27 countries. There is a clear positive correlation between the two variables, with China and India having the lowest income and the most undervalued currencies. This correlation is known as the Balassa-Samuelson effect (Bergin et al., 2004) and shows that China's PPP exchange rate is not unusual given its level of economic development. The contrast between the poor man's Shef index and the rich man's Big Mac index also suggests that as income rises in China, the PPP valuation is likely to correct itself as Chinese people spend more on things like Big Macs and less on basic commodity items in the Shef index.

The international Shef comparisons also raise the question why, although India and China are increasingly mentioned in the same breath in terms of their growth potential and their threat to jobs in rich countries, only China is singled out when India's currency is equally undervalued. Even when absolute PPP deviations persist, there is strong evidence that for most countries, relative price levels in different countries follow the same trend as the nominal exchange rates over the long term. (Figures 2 and 3 show data for the Producer Price Index [PPI] for Japan and South Korea.) When the nominal exchange rate is fixed, then, changes in relative prices can cause an exchange rate mismatch. Figure 4 shows the relative PPI ratio for the United States and China since 1997, a time when many have argued that the RMB was overvalued. The index suggests that relative to the 1997 level, the RMB should have depreciated against the U.S. dollar, but not by a lot: six to eight percent.

Another way of looking at the issue of RMB valuation is to examine the broad, trade-weighted foreign exchange index for both China and the United States-two nations with different trading patterns4 (Table 2). The U.S. trades more with its NAFTA partners and the Euro Zone, while China trades more with Asia-Pacific countries. Figure 5 shows the well-known Federal Reserve Board (FRB) dollar index and a trade-weighted China foreign exchange index that we created to match the FRB index. On a trade-weighted basis, which is really the only basis on which to determine whether the RMB is over- or undervalued, the RMB has actually appreciated more than the U.S. dollar since January 1997! This is mostly because of the devaluation of Southeast Asian currencies. However, if one takes the peak of the U.S. index at the beginning of the 2002 as the starting point, then the RMB has depreciated significantly less than the dollar, largely because the appreciation of the euro and the Canadian dollar have been more significant. But again, the difference is not that significant, and it certainly does not support the conventional wisdom that the RMB was grossly overvalued in 1997/8 and grossly undervalued in 2003/4 against the relevant trade-weighted basket of currencies.

Where Is the Pressure Coming From?

We can examine the conditions of China's external financial balance to see if there has been a fundamental change in the last six years that might portend a sharp, market-driven upward revaluation of the RMB. According to official data, China's current account surplus in 2003 was $46 billion, larger than $37 billion in 1997. But as a share of GDP, the surplus in 2003 (at 3.1 percent of GDP) was smaller compared with that of 1997, which reached 4.1 percent of GDP (see Figure 6). This hardly suggests that the currency was vastly overvalued then and is undervalued now. China's rapidly rising foreign reserves have also been pointed to as a clear indication of the currency's undervaluation. Indeed, at the end of October 2004, China had accumulated $540 billion foreign reserves, the second largest holdings in the world. That is an increase of $137 billion since the end of 2003. Nevertheless, if one uses the standard criteria of the adequacy of foreign reserves, which is the number of months of imports that they can support, the implication is not so obvious. In fact, China's reserves in terms of months of imports have been on a downward trend since 1997 (see Figure 7).5 In the meantime, India's foreign reserves as months of imports have risen sharply from six in 2000 to 10.5 months in mid-2004. Although the rupee is supposedly free-floating, the foreign reserve accumulation as a result of the Bank of India's heavy intervention suggests that it is becoming increasingly undervalued.

A big reason that India's currency is under the radar screen while China's stands out in bold relief is that India's trade of goods and services has not risen nearly as fast as China's. Since its World Trade Organization entry at the end of 2001, China's exports have exploded, even compared with other fast growing Asian countries (Figure 8). However, the trend has to be put into historical perspective. It is actually not that extraordinary when compared with the historical path of Japan, South Korea, and Thailand during their take-off period (Figure 9). What is interesting is that as China's domestic demand growth gradually strengthened, its import growth was even faster. As multinational companies increasingly shifted their manufacturing base, especially the final assembly operations, into China to take advantage of its investor-friendly environment and abundant low-cost unskilled labor, a significant amount of exports from East Asian countries to the United States has now become China's exports to the United States. This is an extremely important point and one that is often overlooked in the debate over "what to do about China." U.S. imports from the rest of Asia have not increased nearly as rapidly as those from China. Upon closer inspection, we find that what's happening is not that U.S. imports are rising because of the RMB currency peg, but rather that China is displacing U.S. imports from its Asian neighbors-as well as from developing nations in other parts of the world, such as Mexico.

Moreover, China is increasingly importing components, raw materials, and capital equipment from its Asian trading partners. Combined with American multinational companies' massive investment into China to build export capacities, China's exports to the United States have taken off in recent years while growth of imports from the United States has been mild by comparison. As a result, even though China's overall trade surplus has been on a declining trend since 1997-hardly an indication that the RMB is undervalued-the trade surplus with the United States has been on a long-term upward trend and has simply exploded over the last two years (Figure 10). That, we believe, is the real, albeit misguided, reason why there is so much external political pressure for China to revalue its currency.

As the global economy surged ahead following the mild recession in 2001, the growing concern over the sustainability issue properly centers on the unbalanced growth patterns between the United States, Japan, and the Euro Zone, rather than on the RMB and unilateral U.S./China trade. U.S. imports and the current account deficit have been rising because of overall structural changes in the U.S. economy, such as continued strong consumer spending and the increasing U.S. budget deficit, and because most of this nation's trading partners have lagged behind in their economic growth and consumer spending. China and the Englishspeaking nations are the exceptions in that they have bolstered their economies and thus increased consumer spending, which exerts a downward pressure on the multilateral U.S. trade deficit, the only deficit that matters.

The dollar weakened significantly since its peak in March 2002 in response to the widening U.S. current account deficit, but there is a widely-held perception that the adjustment process is incomplete. Indeed, the current account deficit kept on growing, and it was only sustained by massive purchases of U.S. debt by Asian central banks, led by Japan and China. As we noted above, since China has become so important in global trade, no other Asian government is willing to allow its currency to appreciate significantly against the RMB, and hence the dollar. It is a small step to conclude, therefore, that the RMB must depreciate against the dollar not because the RMB is undervalued but because the dollar is overvalued.

Should China Bow to the Pressure?

Aside from political considerations, which we will discuss later, the question of whether China should move now is a complex one, relating to several considerations. First, market expectations of the RMB's move have already caused a significant reversal of capital flight and increased upward speculative pressure. Second, cyclical global macroeconomic developments are likely to reduce upward pressure on the RMB. Third, China is in the midst of critical structural reforms, especially in the financial sector, that require focused attention. Fourth, it is increasingly clear that the current economic overheating is sectoral in nature, which is in sharp contrast with the 1993-4 episode. These considerations suggest that it is not in China's interest to revalue the currency at this time. Let's take a closer look at each of these issues.

Re-pegging the RMB

Re-pegging the RMB at a value, say, 15-20 percent higher against the U.S. dollar would instantly vindicate the currency speculators, although they are mostly domestic players. Over the last couple of years, the net errors and omissions category in China's balance of payment has shown a large swing from persistent deficits to a surplus of $7.5 billion in 2003. The net errors and emissions category is believed to capture illegal capital movements. During much of mid- to late-90s, China's capital flight, as a percentage of GDP, was the second worst in the world (only Russia was worse). In fact, it was worse than Mexico in 1994 and South Korea in 1997 during the height of their currency crises. Recently, however, some of this capital is finding its way back, as expectations of RMB appreciation have raised. There is also strong indication that businesses and individuals are involved in currency speculation, which has contributed to the overheating of real estate investment. Revaluing now will encourage future speculation, which could exacerbate the balance of payments pressure.

More Chinese Interest Rate Flexibility

As the Fed continues to boost U.S. interest rates, Chinese authorities have more flexibility to raise domestic interest rates without worrying about widening the interest rate gap and encouraging further hot money inflows. With global economic growth only moderating a bit lately, demand for energy and commodities remains strong, which is likely to keep oil and commodity prices high and to increase the import bill for China and other Asian countries-yet another source of reduced pressure on the RMB.6 Indeed, as long as oil demand remains firm and geopolitical risks persist, the negative impact on Asia's oil importing countries and concomitant, market-driven downward pressure on its currencies will not dissipate.

China's Shaky Fundamentals

Perhaps most important, the sharp cyclical upswing since the end of the SARS crisis is masking China's shaky fundamentals to the outside world.7 Despite modern factories, spanking new airports, highways, and shopping malls, China's social and financial institutions are perhaps comparable to those of the U.S. in the late 19th century period of the "Robber Barons." A 2003 poll conducted by Peking University of about 100 China experts shows that one third of them believe there will be a major crisis in China before 2010. What is the most likely source of crisis? The most frequently mentioned are social (21 percent), financial (19 percent), economic (12 percent), and employment (10 percent). Rapid growth over the last two decades has increased income and social inequality,8 environmental degradation, and regional disparity. The incomplete transition from a centrally-planned economy to a market economy under authoritarian rule has enriched the elite and economic opportunists at the cost of generating a large underclass and eroding public wealth. As some Chinese economists point out, many Chinese local governments are effectively broke and eventually will need a central government bail-out.

Reminiscent of the age of the U.S. "Robber Barons," the widespread, systematic corruption and abuse of power is estimated to cost as much as 14 percent of China's GDP per year. The financial system-which includes the banking, securities, and insurance sectors-needs an urgent overhaul to improve efficiency and be ready for foreign competition under China's WTO commitment. Job creation remains a daunting challenge given continued efforts at transforming the state-owned-enterprises and improving productivity growth. Then there are long-term issues, such as the aging population; under-funded pension and social security systems; and education, health care, and infrastructure issues. As one prominent economist in Beijing observed recently, "other than the central bank, few other high level officials want to talk about the exchange rate issue-there are far more urgent things to address." To attack the problems on multiple-fronts, the top leaders clearly need to ensure stability and focus on the most urgent tasks of strengthening the Party's effectiveness and efficiency on one hand, and reforming the domestic financial sector on the other.9

Weak Link between Revaluation and Internal Adjustment

Finally, based on international evidence (Rogoff, 2004) and China's own experience, it is not at all clear that a revalued RMB will facilitate internal reform efforts. Revaluation of the RMB may not help that much in terms of cyclical macroeconomic adjustment. Despite significant increases in the headline inflation, core inflation remains low. This is a sharp departure from China's historical overheating periods and suggests that there is no systematic price push from aggregate demand, as was the case in 1993-4 (Chu, 2003a). What is unsustainable is fixed investment growth in certain areas even while consumption and investment in other areas still need to be encouraged. China's gross investment as a share of GDP is running at above 40 percent, which is far beyond the 20-30 percent for most developing markets and higher than Japan's and South Korea's levels at a comparable stage of development. Granted, the central government is using very blunt instruments such as credit rationing and administrative orders to address the sectoral imbalances; but this does not suggest that changing the exchange rate right now would be a better alternative. On the contrary, an abrupt change in the foreign exchange regime would increase uncertainty and jeopardize the ability to fine-tune macro policies. Indeed, as Rogoff suggests, abandoning the peg to the dollar could be seen as abandoning China's commitment to stable and sustainable macroeconomic growth.

The Issue Is Mostly Political

The growing U.S. external deficits are clearly unsustainable and must be addressed. It has been argued that the longer the United States waits, the higher the potential shock or damage there will be (Mann, 2004; BCA, 2004; Obstfeld and Rogoff, 2004). But is revaluing the RMB part of the solution to this problem? A close look at the situation suggests that at best it may reduce the problem only marginally in the near term, while the longer-term impacts are unclear since foreign exchange policy changes can bring a host of unintended consequences. However, political reality gets in the way: politicians need to show voters and powerful lobbying groups that they are doing something. Exchange rates are a low-hanging fruit for them, even though they are a small fruit and-from the Chinese perspective-an unripe one. The really effective measures, such as addressing domestic demand imbalances and promoting U.S. goods and services exports, are unfortunately political non-starters in the United States. The perception that undervaluation of the RMB is the cause of U.S. trade deficits has also meant that China's efforts in adjusting export competitiveness through non-foreign exchange measures have received little attention in the political debate.

It has been widely recognized that for the United States, the budget deficits and the relative strength of domestic demand and long-term interest rates between major trading partners are what are driving the huge and growing U.S. current account deficit. One piece of evidence is the fact that there has been "no bang for the cheap buck" since the dollar started to decline in 2002. In the immortal words of the famous U.S. cartoon character, Pogo, "We have met the enemy and he is us!" The U.S. import demand has always been very sensitive to domestic demand. The Morgan Stanley economist Andy Xie estimates that the elasticity of U.S. imports from China for U.S. retail sales has been about four to five in the past ten years.

The other side of this coin is that few U.S. businesses have been able to cash in on China's explosive import demand growth, the fastest in the world at 35 percent a year. Again, there are immovable political and structural reasons why the United States is unable to increase its exports in areas where America is extremely competitive: military equipment, high technology, advanced capital equipment, financial services, tourism, higher education, agribusiness, and so forth. In fact, America's share of China's imports has slipped from 12 percent in 1990 to eight percent last year, while both Japan and the EU are gaining share.10 The U.S. government does its share of legwork to promote exports, but the underlying philosophy is always to let the market work, with the important exception of export controls on products that could have military applications.

To be sure, the decline of the U.S. current account deficit in the late 1980s had much to do with strong domestic demand growth in Japan and Western Europe. As its unfruitful experience dealing with Japan during Japan's lost decade shows, however, the United States has little influence over macroeconomic policies in other G7 countries to push up overseas demand for its exports. The United States should continue to press on its trading partners to boost their economies and to boost their domestic spending and thus their imports of U.S. goods and services. But on this score China cannot be faulted. It is leading the world in increased growth and consumer spending!

It is encouraging that China has also adapted the "letting the market work" philosophy, especially concerning its labor markets, which provide a sharp competitive edge in export growth. In recent years, a popular myth developed that China had an unlimited supply of cheap labor with a horizontal labor supply curve. To almost everybody's surprise, labor shortages and wage pressures are starting to emerge in China's most dynamic export base, the Pearl River Delta. The Chinese Government never sets the wages for those export-oriented factories and allows free movement of migrant workers into the export zone. With rural income rising, some low-level migrant workers have lost interest in jobs that pay less than $100 a month for 10-12 hours per day, seven days a week. Factories and operations that pay the standard 600-700 yuan ($72-$85) per month for basic-level workers have the most trouble attracting employees, but those that offer salaries of 1,000 yuan monthly ($120) have little trouble attracting workers.

Given China's flexible labor market, allowing wages to rise is a natural way to reduce the pressure on external accounts while leaving currency speculators empty-handed. China's flexible labor market is the key to understand how it managed to resist devaluation pressures during the Asian financial crisis of the late 1990s. Sluggish wage growth during the 1998-9 period and high wage growth (relative to productivity) today provide necessary adjustments to effective real exchange rates, while maintaining the peg to the dollar. In addition, China has adjusted export competitiveness through tax policies. During the Asian financial crisis, it implemented value-added tax rebates for exporters, boosting their competitiveness. That policy was partly reversed at the beginning of 2004 when the external surplus was growing too rapidly. The 17 percent VAT rebates that were enjoyed by some export categories, for example, are now revised to only 13 percent. It is estimated that for every three percentage points reduction in VAT rebates, export costs will rise by four percent (Tang, 2004). Thus, China has already allowed its currency to appreciate and has more room to do so through tax policies that affect trade but not the capital account.

One concern about letting wages grow faster than productivity growth is that it will lead to inflation; but in a flexible labor market, abnormal wage pressure will subside as soon as the adjustment period is over. Allowing the market to adjust wages will also naturally close the PPP exchange rate over time without changes in the nominal exchange rate. As wealthier Chinese consumers become more like consumers in other rich countries, the Big Mac index will be a more relevant measure than the Shef index, and the RMB will be less undervalued.11

Looking to the Future

The central point of this paper is that while the RMB is clearly undervalued (especially by PPP measures), there really has been no fundamental change in the valuation that warrants intensive market pressure for it to have depreciated in 1997-8 and to appreciate now. Looking at the broad picture, the relationship between the RMB's peg to the dollar and China's external account surpluses and rising foreign reserves is not as clear as often argued. The contribution of the RMB's undervaluation to external imbalances in both the United States and China is insignificant in comparison with other structural factors, such as domestic demand imbalances for G3 and improving the investment environment (for Foreign Direct Investment-FDI) and export competitiveness in China relative to other countries. There are far better ways to address the imbalances with little distraction for China's challenging domestic reform agenda. In particular, labor costs in China are rising.

China's political capital is best invested in other areas of structural reform. Unfortunately, given its much larger influence on the global economy, China probably cannot say "no" this time to external political pressure12 and may move sooner than it would like. If history proves that China de-pegged before it is capable of handling the shock, the lesson would be that the G-7 failed to recognize that a stable, orderly progressing China is in the best interest of all.

For the longer term, few doubt that China must adopt a more flexible exchange rate regime in this post-Breton Woods environment. A flexible RMB will allow China to conduct independent monetary policy (with an open capital account) and minimize the impact of fluctuations of major currencies, especially the U.S. dollar's gyrations against the euro and the yen. China's outward investment needs are growing rapidly13 and would benefit from a flexible RMB. But first, China needs to clean up the banking system, adjust capital accounts, and develop healthy and robust domestic financial markets. We can expect that a flexible exchange rate will improve China's overall financial system. China has so far learned valuable lessons of the perils of opening the market too soon and allowing a currency to appreciate too fast from the experience of Japan and Southeast Asia. Going forward, it needs to study the positive lessons of liberalizing the exchange rates. The successful cases studies of Poland (from the dollar peg in 1990 to free float in 2000) and Chile (from fixed rate in 1981 to complete float in 1999) clearly show that liberalization can be accomplished without a major crisis; but it requires many gradual, cautious steps to reach the final destination.

ACKNOWLEDGEMENTS

The author is grateful to Tom Walton, Caroline Qian Wang, and Mike Whinihan for their inputs. The author also acknowledges helpful comments from two anonymous referees and NABE meeting participants.