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What If China Revalues?


It would improve US trade competitiveness, stimulate economic activity, boost employment, and eliminate a major source of total US indebtedness.

On March 6, 2010, Chinese Central Bank Governor Zhou Xiaochuan acknowledged that "sooner or later" the peg of the Chinese Renminbi Yuan (CNY) to the US Dollar must end. This statement, together with various economic considerations, has prompted widespread expectations that Chinese authorities may soon allow the CNY to revalue relative to the US Dollar.

Some fear mongering pundits have been warning that this could trigger a US Dollar collapse and an inflationary spiral. More generally, I think that the potential consequences of a revaluation of the CNY are ignored.

In this article we shall explore what a revaluation of the Chinese CNY would mean for the US Dollar and for the US economy generally.

How Would the Value of the Dollar Be Affected?

The value of the US Dollar is usually measured in terms of its relationship to a basket of currencies that comprise the US Dollar Index (USDX). Currently, the composition of the USDX is as follows: Euro (EUR) 57.6%,Yen (JPY) 13.6%, British Pound (GBP) 11.9%, Canadian Dollar (CAD) 9.1%, Swedish Kronas (SEK) 4.2%, Swiss Francs (CHF) 3.6%. PowerShares DB US Dollar Index Bullish (UUP) is an ETF that is based on the USDX.

Please note that the Chinese CNY isn't even part of the US Dollar Index. Therefore, if the question is how the value of the US Dollar -- as this term is generally used in the global financial community -- will be affected by the revaluation of the CNY, the short answer is: Not one iota.

Some might argue that the CNY should be included in the USDX. Precisely for this reason, the Federal Reserve created a trade-weighted index of the foreign exchange value of the US Dollar referred to as the "Broad Index." In this index the weight of the CNY is currently 17.33%.

On the other hand, it's also true that the CNY has for many years been pegged to the US Dollar. Since the CNY's value internationally has been wholly derivative of the value of the US Dollar, in this important sense the CNY hasn't been an independent currency at all. From this vantage point, it is understandable that the CNY has been disregarded when referencing the value of the US Dollar.

In any event, let us focus on the question of what will happen in the future to the value of the US Dollar relative to other world currencies if the CNY is revalued. The first thing that must be understood is that in such a scenario, the CNY will be automatically revalued relative to all the world's other currencies, not just the USD. Therefore, in principle, the value of the US Dollar will decline relative to the CNY, but its value won't decline relative to any other currencies, much less the currencies that comprise the US Dollar Index.

Quite the contrary, the trade deficit that the US has with China is one of the most important fundamental factors weighing against the value of the US currency. Given that a revaluation of the CNY would tend to reduce the US trade deficit with China, this should be a net positive for the US Dollar from a fundamental point of view.

How Would a Revaluation of the Chinese CNY Affect the Fundamentals of the US Economy and Currency?

A revaluation of the Chinese Renminbi would affect US economic fundamentals in various ways. Here we'll focus on US trade competitiveness, employment, aggregate demand stimulus, and debt dynamics.

Improved US Competitiveness

It is widely recognized that the US has a trade competitiveness problem as evidenced clearly by its massive and persistent trade deficits illustrated in the chart below.

However, what few people realize is that the US economy doesn't suffer from a lack of competitiveness in general.

US non-oil trade accounts (exports versus imports) are relatively balanced with the vast majority of nations in the world.

Virtually all of the US's trade deficit is concentrated in its commerce with East Asian nations. Of particular note is trade with China, which in 2009 accounted for 80% of the US's total trade deficit.

What the graph above shows is that China has been "having the US for lunch." And China has been accomplishing this mainly through its policy of foreign-exchange manipulation, which artificially depresses the value of the CNY relative to the US Dollar.

Of course, China isn't the only problem. Most East Asian nations have pegged their currencies to the US dollar at levels that make them massively undervalued.

In the case of Japan, the so-called "Reverse Plaza Accord" in 1995 engineered by the Clinton Administration to bail out a sinking Japanese economy engendered a grotesquely undervalued Yen, which in turn led to perpetual trade deficits for the US in its bilateral trade with Japan.

As can be appreciated from the graph above, a revaluation of the CNY would be a huge step in correcting the massive imbalances that the US has in its current account. However, China isn't the only offending nation. Therefore, the US must be aggressive in insisting that other Asian nations end currency manipulation as well.

Impact On Employment

There can be little doubt that the flip side of massive Asian trade surpluses has been massive job losses in the US and the suppression of US wages in the tradable sectors of the economy. The decline in employment in US manufacturing industries wouldn't have been nearly as great in the past two decades had it not been for currency manipulation by Asian nations. And there can be little question that today, the primary problem in this regard is China.

A substantial revaluation of the CNY would improve competitiveness in US tradable goods sectors, "creating or saving" more jobs than any so-called "jobs bill." The sorts of "job bills" proposed by the Obama Administration are ultimately a zero sum game in which money is taken from one part of the US economy to place it in another.

A revaluation of the CNY, which improves US competitiveness, doesn't take money away from other Americans nor does it compromise the future generations by accumulating debt. To the contrary, if the RMB revalues, Americans and foreigners will be spending more money on US-made goods thereby creating jobs in the US.

Demand-Side Stimulus

It's important to understand that the money that "leaks" out of the US through the current account has the same monetary effect as a contraction in the money supply. Conversely, any reduction in that "leakage" through the trade account has the same monetary effect as an expansion in the money supply.

However, there's something even more important that needs to be understood: Reducing the monetary "leakage" through the trade account has a much more powerful net stimulative effect on the economy than does a Fed-orchestrated increase in the monetary base.

Why? The monetary base is the only monetary variable that the Fed has direct control over. As we've seen, despite the fact that the Fed has radically increased the monetary base, there has been no substantial growth in the money supply as measured by M1, M2, or M3. This is a fact that most people, including a large percentage of financial and economic commentators, do not understand.

Essentially, the money that comprises the monetary base enters the economy through the financial system in the form of credit. Therefore, expansions of the monetary base are only relevant to money supply to the extent that there is demand for credit. Since there is currently little demand for credit in the US, the money supply is not expanding. As a consequence, increases in the monetary base engineered by the Fed have had only a limited effect in stimulating economic activity.

By contrast, the monetary stimulus occasioned by reducing capital leakage through the current account is far more effective because it will be accompanied by an increase in effective demand.

Revaluation of the CNY will create greater incentives on the part of consumers and investors to purchase US-made goods and to invest in US-based businesses because the relative prices of Chinese consumer and investment goods will rise relative to those in the US. This stimulation of effective demand will cause a real expansion of the money supply along with concomitant increases in real economic activity.

Debt Dynamics

The trade deficit represents an excess in what the US consumes on aggregate relative to what it earns on aggregate. This excess of consumption relative to income essentially has to be financed with debt. In the decade prior to the onset of the economic crisis in 2007, the total cumulative US trade deficit has been about $4.89 trillion. This accounts for a very substantial proportion of the massive growth in total US public and private indebtedness during that period. Today, the trade deficit with China accounts for 80% of this major source of US indebtedness.

Thus a revaluation of the CNY, as well as the currencies of other East Asian nations, will eliminate a major source of total US indebtedness.

The Downside of CNY Revaluation

Will there be potential downsides to an eventual CNY revaluation? Sure there will. Economics is all about trade-offs.

Perhaps the most important potential negative relates to the fact that the artificial undervaluation of the CNY relative to the US dollar has served as an "anchor" in US inflation dynamics. This is so because competitive pricing pressures from Chinese manufacturers haven't allowed US competitors to raise prices.

Will US producers automatically raise prices in response to a revaluation of the CNY? Some will. However, the vast majority won't. And those that do won't do so in any significant degree. To understand the potential effect of a revaluation of the Chinese RMB on US inflation, let's review a few relevant facts:

1. The CNY is irrelevant to prices of most US goods. The US economy is overwhelmingly a service-sector economy and CNY revaluation will have virtually no impact whatsoever on the roughly 70% of the US economy involving services. More than 20% of the US economy involves goods that China and Asian nations simply don't produce (e.g. oil). Less than 10% the US economy involves tradable goods that are in direct or indirect competition with China and/or other Asian producers. Therefore, contrary to widespread belief, a revaluation of the CNY and/or other major Asian currencies can have only a limited effect on US inflation.

2. Many Chinese companies won't raise prices. Many Chinese companies may choose to maintain their dollar prices constant and absorb the hit on their profit margins to preserve market share. This will allow no scope for US producers to raise prices.

3. Many affected US producers won't raise prices. Even if some Chinese producers choose to raise prices to some extent, many US producers will strategically prefer to maintain current pricing and attempt to raise their volume of sales and gain market share.

4. Excess capacity and unemployment. Excess capacity in capital equipment and labor will allow many US producers to expand production and increase their profit margins without raising unit costs. Indeed, it is conceivable that by expanding the volume of sales, some producers could gain economies of scale that would allow them to actually lower the final sales prices of their products thereby enabling them to gain market share on Asian competitors.

5. Marginal price increases. Some US tradable goods producers may choose to raise prices to some degree, although for the reasons cited above, it is highly unlikely that they will do so proportionately to the rise in the value of the CNY.

6. Improved profits and wages. The improved profitability of US producers in the tradable sector due to increased volumes and greater pricing power could eventually allow some scope for wage increases in manufacturing industries.

So let us summarize the "downside" of CNY revaluation: Increased volume of sales by US producers, increased hiring of US workers, better profit margins for US companies, and higher wages for US workers.

Does that sound so terrible?

Sure, the Fed needs to be careful to not allow the money supply to expand too rapidly with the effective increase in final demand. Sure, some pockets of inflationary pressure could emerge in segments of the tradable goods sector that are directly or indirectly exposed to Chinese production (constituting a very small part of the overall US economy).

But to say that a revaluation of the CNY and other Asian currencies would be "bad" because it might eventually cause some risk of inflation is a bit like saying that administering medicine to a bed-ridden patient is "bad" because he might soon get up and run the risk of being run over by a car.


Fear mongering about the consequences of a potential revaluation of the Chinese Renminbi is just that, fear mongering. There is little to no possibility that this could bring about a dollar collapse or significant inflation.

What about the notion that a strong Dollar is good for America?

My answer is that this slogan has got it backward. It would be far more accurate to say: A strong America is good for the Dollar.

A revaluation of the CNY would improve US trade competitiveness, stimulate economic activity, boost employment, and eliminate a major source of total US indebtedness. This is good for the US economy, and ultimately, it is good for the US Dollar.
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