Rolf J. Langhammer
US President-elect Donald Trump has continued branding China as a currency manipulator – accusing the country of keeping the yuan low to help Chinese exports and harming jobs in the US. But in fact China’s currently intervenes in the opposite direction to prevent a weakening of the yuan – supporting American Jobs.
After his election as the future US president, Donald Trump has renewed his previous rants against China. In a recent series of angry tweets, he accused the country of impeding US exports and threatening US manufacturing jobs by depreciating its currency. Nothing could be further from the truth. While it is right to assume that China manipulates its currency, Trump barks up the wrong tree if he accuses China of having an undervalued currency. China’s present currency interventions go in the opposite direction: rather than devaluing the yuan to protect the Chinese export industry, the authorities prop it up in the face of external depreciation pressures. This is more likely to help than harm the American worker.
Downward pressure on the yuan
The recent downward trend of China’s currency was not the result of government policies to suppress domestic demand or to weaken the yuan by exchanging it against dollars. The yuan’s weakness is a result of market developments both in China and in the U.S. Chinese households and companies have jumped to new opportunities to use local currency for non-Chinese asset purchases (in particular for FDI), especially because of perceived higher profit margins abroad. This is understandable in the light of declining average and marginal productivity of capital as China transitions into a new stage of lower growth, which is inward-oriented, innovation-driven and focused on high quality services production.
In the U.S., Trump promises to fuel the domestic economy through a massive fiscal expansion program, which promises job creation in the short run regardless of its medium or long-term financial sustainability. Together with an expected increase in the Federal funds rate and continued weaknesses in European economies, the announcement of a domestic expansion program strengthens the dollar and causes the Chinese Central Bank to reassess its currency basket exchange rate targeting, which is centered around the US dollar.
China moves to stem outflow of capital
Rather than raising domestic interest rates to prop up the yuan, Chinese authorities have opted for restricting capital exports as the seemingly less costly measure. Without controls and without abandoning exchange rate targeting, higher interest rates would have been the only effective tool against capital outflows. But deploying it would have come at the cost of an unwelcome slump of domestic demand and of GDP growth in China.
Capital export controls on the other hand allow the government to steer foreign investment into areas that align with China’s industrial policy targets of technological upgrading (“Made in China 2025”) and to discourage or prevent private business investment with the sole goal of profit making and asset spreading, such as investment in international hotel chains. This is of course based on the doubtful assumption that the government is a better strategic investor than private businesses.
If capital controls are not enough to stem the yuan’s decline, China’s Central Bank could intervene in foreign exchange markets by selling dollars – as it has done since mid-2015 when unexpected changes in its exchange rate regime plus volatilities in Chinese stock markets caused disturbances in international financial markets and pressure on the yuan.
Without doubt, both measures can be characterized as currency manipulation, but contrary to Trump’s allegations, China’s current monetary policy is economically more costly for China than for the U.S. If Chinese capital is not allowed to leave the country, there is a danger that it will be wasted in domestic sectors that would not be profitable under free market conditions. Given that capital is no longer as abundant in China as it used to be, such resource misallocation can impede the ambitious “Made in China 2025” targets.
High economic and political costs
Secondly, strict capital export controls could carry high political costs for China. Chinese authorities risk a confrontation with foreign investors, who will try to repatriate profits by using so-called “transfer pricing” strategies of under-invoiced their exports and/or over-invoiced their imports if normal channels of profit repatriation are narrowed or even closed. Many of these investors come from the U.S. and could lodge official complaints with the new US government if profit repatriation should be severely hindered.
Domestic investors would also be tempted to use informal channels to export domestic currency and buy assets abroad. The yuan’s gradual internationalization helps Chinese capital owners to shift money abroad. The higher the financial rewards from bypassing controls, the more resources would be spent by the private sector to export capital and the more resources the Chinese authorities would have to deploy to fence it in.
Finally, a drastic tightening of capital export controls in China could lead to a reassessment of the International Monetary Fund’s positive judgement on the yuan as a “freely usable currency,” and it could weaken incentives for the world’s leading Central Banks to hold greater shares of their reserves in yuan.
Chinese authorities have embarked on a risky path by building a fence around their currency. The introduction of stricter capital export controls in China violates the spirit of a globalized economy as much as Trump’s protectionist policy announcements would if they were implemented. With China shutting off its financial markets and the U.S. closing off its markets for the trade of goods, the global economy is truly in the doldrums.