My Blog

December 3, 2007

MON 3 DEC 2007

The value of the RMB does matter to the trade balance (1) By Michael Pettis

In today’s Financial Times there is an article by Mure Dickie that describes a report by the Conference Board, a US-based research organization, on the relationship between the RMB and trade balances. I tried to get the report myself but was unable to find a place from which to download it, so I have not been able to read it, although I did see that a number of other sites made reference to this report.

 

Dickie summarizes the report in this way:

 

China’s soaring trade surplus with the US has “very little to do” with an undervalued renminbi, and faster appreciation of the currency, though welcome, would be “no panacea”, according to a new report…

 

“Faster currency appreciation, especially when combined with greater flexibility, would make it easier for the government to redress internal and external economic imbalances, but it is not a panacea and appropriate calibration is difficult,” the Conference Board report said.  “Although an undervalued currency contributes to China’s trade surplus, it is not a primary cause of it and has very little to do with the bilateral United States-China trade deficit,” it added.

 

The report said that extraordinary growth in productivity had been the main driver of Chinese competitiveness, creating profits that companies pour back into investment that in turn leads to greater profits.

 

As Dickie points out, this report has come out in the midst of a renewed set of calls for an RMB appreciation – two days ago Japanese authorities added their voices to US and, increasingly strident, European calls for faster appreciation. This has made the report particularly topical.

 

Not having read the report, I don’t want to misrepresent what it says, but from the descriptions I have read in Dickie’s article in the Financial Times and elsewhere the report seems to be to making the by-now-standard argument that the an RMB appreciation will not cause a significant direct shift in trade dynamics.  I think this is probably true as far as it goes, but misses the point.  In fact the level of the RMB is key to the whole issue of China’s balance of trade – not because of the direct impact of the RMB on relative pricing levels, but rather because of the impact of the currency regime on domestic monetary conditions, which are at the heart of the trade balance.

 

Perhaps because of renewed international pressures on China I have been getting a lot of emails on the subject of the relationship between the RMB and Chinese trade, so the Conference Board’s report provides a good excuse to try to summarize why I think the level of the RMB matters a lot to the balance of trade. First of all it is worth noting that Chinese authorities and other supporters of China’s currency regime have made two conflicting arguments about the relationship between trade and the level of the RMB. 

 

One argument points to studies, like the one I assume the Conference Board produced, that suggest that changes in the level of RMB will not significantly affect the size and direction of China’s exports, largely for three reasons: First, a significant portion of China’s exports (I think the last number I saw was between 40% and 50%) consists of the re-export of imported goods that were simply processed in China.  An RMB revaluation, of course, will have very little net impact on the export prices of these goods because while it raised the dollar value of RMBs, it would reduce the RMB value of any imported good by exactly the same amount. 

 

When we include the impact of other imported commodities, such as oil and metals (and imported food, which impacts wages), whose prices, like those of the re-exported imports, would be reduced by an appreciation of the RMB, the net direct and indirect impact of an increase in the RMB, assuming profit levels remained unchanged, is significantly less than the headline appreciation. A 10% appreciation of the RMB, in other words, would reduce the dollar value of Chinese exports by significantly less than 10%, even if all other factors remain unaffected by the appreciation.  (By the way this argument is often overstated: certain commodity prices, most importantly oil, are set by the government at subsidized levels and it is extremely unlikely that these prices would drop in RMB terms with an increase in the dollar value of RMB.)

 

The second reason why changes in the level of RMB will not significantly affect the size and direction of China’s exports is that given recent domestic productivity growth, Chinese companies have high enough profit margins and enough pricing power domestically that the pricing impact of an appreciation could be partly mitigated by reducing profit margins and perhaps domestic input costs.  In other words let’s assume, continuing with the example above, that a 10% appreciation resulted in a 5% increase in the average cost of export goods assuming no change in profit margins and domestic costs.  By reducing profits and pushing costs down, Chinese corporations can ensure that the increase in the dollar cost of the products to be exported can be reduced even further.  We know that in the past Chinese (and other Asian) exporters have reduced profit margins in order to keep market share, and it is reasonable to assume that they will do the same in the future – and recent rising profits may have made it all the easier to do so.

 

Finally in many, if not most, of its markets China has become so dominant that it has significant pricing power, and in many cases actually sets global prices.  This means that if Chinese companies were forced to raise their export prices because of RMB appreciation China would not suddenly see a collapse of its exports.  Instead, the price of goods in Europe and America in which China had a significant market share (which corresponds to much, if not most, of its exports) would rise.  In fact there might even be, paradoxically, a temporary increase in the total dollar value of Chinese exports if the increase in prices exceeded the resulting reduction in export volume.