Friday, October 15, 2010

How Successful Is China's Currency Manipulation?

The US Treasury has been reluctant to name China as a currency manipulator. It fears that official use of these words would be seen as the start of a trade war. In the plain-English sense, however, China certainly does manipulate its currency, doing so by frequent intervention in foreign exchange markets. Heated rhetoric aside, the real question is, how successful has the manipulation been in maintaining the competitiveness of Chinese exports?

To answer that question, we need to look not just at nominal exchange rates, but at real rates. In nominal terms, the yuan has strengthened about 2.5% since China's June 19 decision to ease its currency policy. That works out to an annualized rate of nominal appreciation of almost 8%. The simplest way to calculate real appreciation is to add on the difference between China's inflation rate (3.5%, according to August data) and US inflation (about 1%, or even less if the dip in the September figures holds up). Doing so gives us an annual rate of real appreciation of more than 10%. Two or three years of that would pretty well eliminate the 20 to 40% undervaluation that critics are talking about. True, three years is longer than the time horizon of your average politician, but it's not exactly a glacial pace of change, either.

But wait, you might say, we can't be sure that China will continue to allow an 8% rate of nominal appreciation. The latest hints from inside the PBoC suggest that 3% nominal appreciation could well be the maximum. Wouldn't that mean it would take a lot longer to correct the existing undervaluation?

No, not necessarily. In order to slow the rate of nominal appreciation, the PBoC would have to step up its currency intervention. Chinese inflation is already accelerating month after month. Slowing nominal appreciation from its recent 8% pace would increase inflationary pressure even more, both by keeping import prices from falling, and via the newly minted yuan that intervention pumps into China's domestic money supply. With inflation accelerating further, the rate of real appreciation might not slow by much, if at all.

The bottom line: Yes, China is a currency manipulator, but not a completely successful one. Condemning as trivial the 2.5% appreciation of the yuan since June sounds good in the halls of Congress, but that number far understates the rate at which the yuan is really losing its competitive edge against the dollar.

Flash footnote (published on Treasury web site shortly after the above post)

"WASHINGTON – Secretary of the Treasury Timothy Geithner recognized China's actions since early September to accelerate the pace of currency appreciation, while noting it is important to sustain this course.

Since June 19, 2010, when China announced it would renew the reform of its exchange rate and allow the exchange rate to move higher in response to market forces, the Chinese currency has appreciated by roughly 3 percent [sic] against the U.S. dollar. Since September 2, 2010, the pace of appreciation has accelerated to a rate of more than 1 percent per month. If sustained over time, this would help correct what the IMF has concluded is a significantly undervalued currency. "

Follow this link to download a free set of classroom-ready slides discussing China's currency policy and the real exchange rate. An earlier version of this post appeared on


  1. I agree in principal with your focus on the real rather than nominal exchange rate. However, defining this should be based on a productivity adjusted inflation measure rather than just CPIs, thus, unit labor costs. This is in part because China's massive investment program keeps raising capital/labor ratios, maintaining very high rates of productivity growth. Of course diminishing returns will ultimately emerge and China's labour market is much closer to equilibrium than in the past so wages are beginning to rise. But, using ULC based estimates of real exchange rates estimates the CNY is both significantly undervalued and is not closing this valuation gap very rapidly. Models are nice, what does the real world say? China's exports continue to grow powerfully, its market share in global exports continues to rise, and its trade surplus has begun to rise again on a trend basis.

  2. Good points, Ray. Yes, you are right, ULC weighting is an important variant of the real exchange rate, and probably better than CPI weighting for competitiveness issues. However, CPI numbers are published more currently, and they are all there seems to be for June-Sept 2010, which is the focus of my post. If you have a link for ULC data for US or China for this period, please send it to me, and I'd be happy to run the numbers.

    The BLS reports that earlier this year, US manufacturing unit labor costs were falling very fast--down 8 percent in Q1 and 5.8 percent in Q2. It is hard for me to believe (in face of the tightening Chinese labor market, news of strikes and big wage settlements in key export industries, and the pressure of rising CPI cost of living) that Chinese ULC is falling faster than US ULC, and if not, the ULC real exchange rate gap is closing just like the CPI gap. In fact, I would be surprised if Chinese ULC is not rising, but as I said, I don't have the numbers at hand.

    As for China's exports, let's watch how the trend holds up. Yes, it is true that exports bounced back fast from their recession lows, but they are still only a whisker above their prerecession highs of two years ago, and the latest data point--September 2010--was a downtick.