Recently, a bipartisan group of 60 U.S. senators made headlines with a letter to Treasury Secretary Jack Lew. The letter urged him to add a clause to the proposed Trans-Pacific Partnership trade agreement prohibiting currency manipulation. The senators cited a Peterson Institute study that claimed currency manipulation had cost the United States 5 million jobs. Subsequent discussion of the issue focused on China and Japan as the biggest manipulators. How big is the threat? What should we do about it?
China’s traditional currency manipulation
There is no doubt that China is a currency manipulator in the traditional sense that it treats its exchange rate as an explicit goal of economic policy. It shares this distinction with other countries with currency regimes that are of the “fixed” or “managed float” varieties. We could quibble about which of these categories China belongs to. Its currency regime is less rigidly fixed than, say, the currency boards of Bulgaria and Hong Kong, but less flexible than the managed float of, say, Russia. Either way, as the following map shows, currency manipulators — the light green and blue countries — are clearly in the majority among the world’s economies.
What is at issue, then, is not whether China is a currency manipulator, but rather, how effective its manipulation is and whether and how that manipulation poses a threat to the United States. Over the past three years, I have written a series of posts    arguing that China’s currency manipulation has not been highly effective and that the harm done to the United States is often exaggerated.
To get a clear picture of the effectiveness of China’s currency policy, we need to look at the evolution over time of its real effective exchange rate. The REER is a weighted average of a country’s exchange rates with each of its trading partners that has been adjusted to reflect differences in rates of inflation. It is often used as a measure of a country’s global competitive position.
In 2010, at the height of the controversy over China’s currency manipulation, various observers estimated that the yuan was undervalued by 20-40 percent. Since that time, as the following chart shows, the yuan has appreciated by about 20 percent, as measured by its REER. Meanwhile, the REER for the United States, after a dip in 2011, has returned to just below its average level for 2010. All in all, the chart suggests that between half and all of the undervaluation thought to exist in 2010 has since disappeared.
Furthermore, the REER does not tell the whole story. For an even better indicator of countries’ relative competitiveness in goods, we should adjust nominal exchange rates not by consumer prices, as the REER does, but by changes in unit labor costs. The evolution of unit labor costs reflects both changes in nominal wages and changes in productivity. There does not seem to be an official data series on China’s unit labor costs but, as pointed out in the earlier posts, such data as there are clearly indicate that China’s unit labor costs have been rising rapidly. By contrast, in the United States, wages have barely kept up with productivity, so unit labor costs have changed little. It seems likely that the real bilateral exchange rate of the yuan against the dollar, deflated by relative unit labor costs, has appreciated by 40 percent or more over the past three years. That is presumably a major cause of the rapid decline of China’s current account balance (next chart) from its towering levels of the mid-2000s.
Why have China’s efforts at currency manipulation failed? There are two likely explanations.
One, discussed at length in the earlier posts, is purely technical. When pushed too far, building up reserves of foreign assets to maintain an artificially low value of the yuan has harmful side effects. The most direct of these is to fuel inflation. The Peoples Bank of China tries to limit the inflationary consequences of its foreign exchange operations by “sterilization,” that is, by offsetting purchases of U.S. Treasury securities by selling yuan-denominated securities of its own. However, sterilization has adverse effects on banking and financial markets. To avoid the worst of these side effects, China has allowed the yuan to appreciate gradually, rather than holding the exchange rate totally fixed.
The other explanation for gradual appreciation of the yuan is political. An undervalued yuan helps some interests in China, especially those of its exporters. However, it harms other interests, in particular industries that rely on imported inputs, both high-tech components and raw materials, and middle-class consumers of imported goods. Some observers think the latter groups have gained in relative political clout, offsetting pressures from exporters to hold the yuan at a deeply depreciated value.
Whatever the explanation, the bottom line is that China’s currency manipulation has not been highly effective, nor, at the present exchange rate, does it demonstrably do great harm to the United States.
Japan’s indirect currency manipulation
Japan poses a different set of issues. The world map presented earlier shows Japan in dark green, putting it among the minority of the world’s countries with freely floating currencies. In what sense, then, can we consider Japan to be a currency manipulator?
The answer is that Japan’s alleged currency manipulation is not, for the most part, accomplished through direct intervention in foreign exchange markets. (I add “for the most part” because the Bank of Japan is not so Simon-pure in maintaining a free float as is the Fed or the European Central Bank.) Instead, it takes the form of massive purchases of domestic assets by the Bank of Japan — that is, through quantitative easing (QE).
The latest wave of QE in Japan is part of “Abenomics,” the package of expansionary policies inaugurated by Prime Minister Shinzo Abe after he took office in December 2012. As the next chart shows, the yen has depreciated substantially since that time, and is now some 25 percent below its peak. The depreciation started before Abe took office, but the early months of the trend may have, at least in part, reflected expectations based on his campaign promises.
U.S. firms that export to Japan or compete with imports from Japan have not been at all happy with the weakening of the yen. However, there are two good arguments against the kind of retaliatory measures advocated by the bloc of 60 in the U.S. Senate.
The first reason is that any harm to U.S. exporters and import competitors is offset by gains to U.S. consumers of Japanese imports and firms that use imported Japanese inputs. In large part, the outrage of the letter-writing senators simply reflects the fact that interests favoring a strong yen have better lobbyists than those favoring a weak yen.
The second reason is that the quantitative easing under Abenomics is not currency manipulation in the classic sense at all. It is, instead, domestic monetary policy aimed at pulling Japan out of its long period of deflation. As such, it is no different from QE as carried out by the Federal Reserve.
True, Japanese QE has the indirect effect of causing depreciation of the yen, but in exactly the same way that earlier rounds of QE by the Fed in 2010 and 2011 caused the dollar to depreciate. The above charts show that clearly. What is more, the recent uptick in the dollar’s exchange rate is widely attributed to market expectations that the Fed will soon begin to taper off on QE.
In short, even if, like the 60 Senators, we were to choose to side with exporters and import competitors and against U.S. consumers, we should be very careful about throwing stones, given the glass house the Fed has built for itself.
What, then, should we do about currency manipulation?
This brings us to the main question: What should we do about currency manipulators?
We need not retaliate against China, because its traditional currency manipulation has largely ceased to be effective. Any harm it might have been doing three years ago has largely dissipated as the yuan has appreciated. Besides, by world standards, China is a piker among currency manipulators. The Peterson Institute study suggests watching the change in a country’s foreign currency reserves as a percentage of its gross domestic product as a measure of currency manipulation. Using the institute’s own data, China’s reserve accumulation for 2012, through the date of publication, came to a mere 1.9 percent of its GDP, compared to 4.9 percent for Denmark, 29 percent for Norway, and a whopping 35 percent for Switzerland.
As for Japan, we have no right to retaliate because its indirect currency manipulation via quantitative easing is exactly what we are doing ourselves. When the Fed initiated QE2 in 2011, the dollar fell sharply, and trading partners like Brazil protested that the Fed was engaging in a “currency war.” The U.S. government answered that QE was domestic policy and none of their business. Precisely the same is true of Abenomics. If Japan is one of the big Trans-Pacific currency manipulators, then we are even bigger.
The answer, in short, is that we do not need to do anything about foreign currency manipulators — not the Danes, not the Swiss, and not our prospective partners in the new Trans-Pacific agreement. Let’s move on to other issues and leave this one behind.
Don’t Miss Ed Dolan’s “Quantitative Easing: Your Ultimate Cheat Sheet to the Monetary Policy.”