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RENMINBI CONTROVERSIESMorris GoldsteinNo topic in international monetary economics has probably been more debated over the past three years than what should be done about China’s currency regime and about the exchange rate for the renminbi (RMB). In this article, I take up three questions that are at the center of the current debate, namely:① Is the RMB undervalued and, if so, by how much?② Would an RMB appreciation of 20–25 percent be particularly harmful for China’s economic growth and development, as well as for its domestic financial stability? ③ Was the July 21, 2005, currency reform a large or tiny step forward？⑴Is the RMB Undervalued?Among the many approaches available for estimating equilibrium exchange rates, I prefer two: the “underlying balance” approach and the “global payments” approach. In both cases, I am going to assume that no wholesale change occurs in China’s capital-account regime over say, the next three years.⑵ Under the underlying balance approach, one asks what level of the real effective exchange rate—that is, the trade-weighted average of nominal exchange rates adjusted for inflation differentials between the home country and its trading partners—would produce equilibrium in the home country’s balance of payments, where equilibrium means an “underlying” current account position that is approximately equal (and opposite in sign) to “normal” net capital flows. Suppose we take the average of China’s capital account balance over the 1999–2002 period—a surplus equal to percent of gross domestic product (GDP)—as a rough estimate of its normal net capital flows.⑶ China’s capital account surplus in 2003 and 2004 was much larger than that—on the order of 7–8 percent of GDP—but much of that appears to have been driven by speculative capital inflows, induced primarily by an expected appreciation of the normal net capital flows are in surplus by percent of GDP, equilibrium then calls for an underlying current account deficit equal to percent of GDP. The “underlying current account” can be defined as the actual current account balance adjusted for two factors: cyclical movements in the economy that make the demand for imports unusually high or low, and the lagged trade effects of earlier exchange rate changes that are not yet visible in the published statistics. China’s actual, overall current account surpluses in 2003 and 2004 were and percent of GDP, respectively. The underlying current account surplus was undoubtedly higher than the actual ones in those two years because the overheated state of the Chinese economy was pushing the demand for imports way up and because the real, trade-weighted value of the RMB depreciated during that period, suggesting positive trade-balance effects in the pipeline (see Goldstein 2004). Without pretending to undue precision, the underlying current account surplus in 2003–2004 was probably in the neighborhood of –5 percent of GDP. China’s actual global current account surplus in 2005 was much larger still. Based on official figures just recently released, the actual current account surplus last year was percent of GDP. The underlying surplus would be somewhat lower because domestic demand growth slowed in China last year—reducing the growth of imports— and because the RMB appreciated in real, trade-weighted terms in 2005.⑷ Nevertheless, the underlying current account surplus in 2005 was likely on the order of 5–6 percent of GDP. The foregoing implies that China’s current account balance needs to deteriorate by a whopping – percent of GDP to restore equilibrium to its overall balance of payments. If one does some simulations with a small trade model to calculate what size real appreciation of the RMB would generate such a large negative swing in China’s current account—using a range of plausible price elasticities, giving due consideration to how the high import content of China’s exports affects its export prices, and making alternative assumptions about the second-round feedback effects of income changes on the demand for imports—the answers tend to congregate in the 20–35 percent range.⑸ Note again that this estimate of undervaluation of the MB is not dependent either on the large speculative capital inflows of recent years or on China’s large and rising bilateral trade surplus with the United second complementary approach, the global payments approach, asks what role RMB adjustment should play in the correction of large existing payments imbalances around the world—not just in China. Here, the elephant in the room is the large . current account deficit—running at about percent of GDP in 2005 and threatening to go higher over the medium term (see Cline 2005). An analysis of . external debt dynamics suggests that a deficit only about half that size is likely to be sustainable. As argued by Mussa (2005) and others, one key element in any effective strategy to correct the . external imbalance, while simultaneously sustaining healthy global economic growth, is a further depreciation in the real trade-weighted dollar from its current level—on the order of 15–25 percent.⑹ Emerging Asia plus Japan account for about a 40 percent weight in the trade-weighted dollar index. Whereas the euro, the Canadian dollar, and the Australian dollar, among other market-determined exchange rates, have shown strong (real effective) appreciations during the first wave of dollar depreciation (since February 2002), the Asian currencies—with the notable exceptions of the Korean won and Indonesian rupiah—have either appreciated only slightly (., Thai baht and the Indian rupee) or have actually depreciated.⑺In some cases (the Malaysian ringgit, the Japanese yen, and the Taiwanese dollar), the depreciation has been large despite sizable current account surpluses. If the Asian currencies do not lead the way in the needed second wave of dollar depreciation, either the resulting overall depreciation of the dollar will be too small, or the burden of appreciation will fall heavily on economies where a further large appreciation would not be warranted by their economic circumstances (see Goldstein 2005).⑻ Under the global payments approach, China is a prime candidate for significant real currency appreciation: it has experienced massive reserve accumulation equal to 10 percent of GDP over each of the past three years; its real, trade-weighted exchange rate has depreciated over this period; and it has now recorded 10 successive quarters of 9 percent plus economic growth. Moreover, an appreciation of the RMB would likely induce some appreciation in some other Asian currencies. To sum up, the message I take away from these approaches to assessing the equilibrium value of the RMB is that it remains significantly undervalued on a real, trade-weighted basis— on the order of 20– 35 percent.⑼A wholesale liberalization of controls on capital outflows could wipe out most of this undervaluation, but the fragile state of China’s banking system makes this policy neither desirable nor likely for the next several years. True, there are other approaches to valuing the RMB (., purchasing-power-parity calculations, structural models of the RMB, and VAR models), and there are other ad hoc adjustments one could make to obtain estimates of underlying current accounts and normal capital flows. None of those approaches, however, yields results persuasive enough and different enough to overturn the large undervaluation verdict.⑽Would an RMB Revaluation Be Bad for China’s Growth and Financial Stability?Many have argued that even if the RMB is undervalued, it would be most unwise to undertake a large revaluation since this could be catastrophic for China’s growth and economic development, as well as its social and financial stability. In this context, some opponents of RMB revaluation emphasize the large-scale and continuing migration out of agriculture, the sizable employment losses in state-owned industries, and the large annual flow of graduates looking for work. Taken together, these labor force trends are said to create irresistible social pressures for rapid economic growth that can only be accommodated with the high export growth emanating from a highly undervalued exchange rate. Still others opposed to revaluation assert that the rigid link of the RMB to the dollar—along with its undervaluation —has served as an essential pillar of China’s domestic financial stability and as a way of encouraging large inflows of foreign direct investment that can compensate for the weaknesses of China’s domestic banking find these arguments against a significant RMB revaluation unpersuasive. Getting the arguments right about the benefits and costs of an RMB revaluation is important because China cannot be expected to undertake an exchange rate policy that is perceived to be counter to its self-interest. Let me offer three observations. First, it is an exaggeration both to equate any significant real appreciation of the RMB with very slow growth and to regard exports as the main driver of China’s growth. Between 1994 and early 2002 the real, trade-weighted exchange rate of the RMB appreciated by almost 30 percent (see Figure 1), yet the Chinese economy grew at an average annual rate of 9 percent and growth never dipped below 7 percent growth in any single year (see Figure 2). True, this large real appreciation of the RMB did not come all at once, but there were individual years in which the appreciation was 8 percent or more (13 percent in 1997 and 8 percent in 2000).⑾Also, the record over this eight-year period demonstrates that the Chinese economy is capable of growing at a robust pace when the real exchange rate is following strong trend appreciation. The export-to-GDP ratio in China is now approaching 35 percent. But as Anderson (2005a) has recently argued, this does not mean that the Chinese economy is “ export led.” Adjusting for the relatively low domestic content of exports makes China’s “ true” export exposure lower than suggested by the headline export-to-GDP ratio. Anderson (2005a) goes on to argue that one salient characteristic of an export-led economy is that fluctuations in trade growth should be similar to those in broader GDP growth— whereas an economy that relies more on domestic demand for growth would display fluctuations in GDP growth that were considerably smaller than those for trade growth. On this count, Anderson (2005a) finds that while the standard deviation of trade growth has been very similar to the standard deviation of GDP growth for a group of seven Asian economies, the standard deviation of GDP growth has been only about a third as high as that for trade growth in China. In fact, the relationship between GDP growth and trade growth in China looks much closer to that in the United States than it does to China’s Asian neighbors.