The People's Bank of China (PBoC) cut the 7-days reverse repo rate by 25 basis points to 2.5 percent for the first time since Oct, 2015 - Photo: Special

JAKARTA (TheInsiderStories) – The United States (US) Treasury officially labeled China a “Currency Manipulator” on 9th August 2019.  The nomenclature is a legal definition under the 1988 Omnibus Foreign Trade and Competitiveness Act.  This is the first time it has happened since 1994 when China was last officially given this designation.

Given that the US and China are already engaged in what can only be described as a trade war, the official designation has little ramification over and beyond the fact that it highlights the gulf that exists between the two countries as to what constitutes a fair trading relationship.

At another level though, at least as far as proponents of the current US stance towards China are concerned, the move silhouettes the present US administration’s determination to tackle China’s unfair trade practices against the lackluster and ineffective efforts of previous administrations.

It fulfills an election promise. It also calls into question whether the existing legal and institutional framework, both in the US and internationally, is enough to ensure that the country is operating on a level playing field when it comes to international trade and investment.

While we explore the arguments for and against the case that China manipulates its currency, it is important to remember that the current level of economic engagement between the US and its main geopolitical and economic rival is new.

No such economic relationship existed between the USA and the Soviet Union, and much of the legal and institutional framework built around ensuring free and fair trade has as its premise the idea that all parties are either market economies or in the transition towards being a market-driven economy.

It is doubtful that a State-driven economy, particularly in an authoritarian state, can ever have a free, unmanipulated exchange rate. Control over outbound investment and incoming portfolio and direct investment, industrial policy towards exporters and constraints on market access for importers are all going to influence the exchange rate in ways that run counter to market forces.

What does the data show?

Opponents of the move to label China a currency manipulator, both inside and outside China, have some compelling arguments. The Treasury’s own semi-annual report to congress in May 2019 failed to designate China a currency manipulator.

What has changed since May? Nothing. The treasury failed to make the designation then because China fulfilled just one of three criteria required to qualify as a currency manipulator: it runs a large trade surplus with the US.

It does not, however, run a large current account surplus relative to its own GDP – the threshold being 2 percent – nor did it intervene actively in the market in a way designed to generate an unfair advantage in trade during the period under review. Furthermore, China has drawn down its foreign exchange reserves in recent years to support the value of the Yuan as opposed to suppressing it.

Foreign exchange reserves have fallen from a high of US$4 trillion in June 2014 to $3.1 trillion. Given that the reserves earn a return of perhaps 3 percent per annum, the implication is that China has spent about $1.2 trillion dollars defending the value of the RMB to its own detriment as far as trade practices are concerned.

The case that China has spent recent time defending the value of the RMB against depreciation was succinctly put by Mark Sobel of the OMFIF when he said: “China over the last year had been propping up the renminbi against downward pressures by jawboning and talking to its banks, fixing the renminbi higher than the market price, squeezing short positions and tightening capital controls. It is foolhardy to argue China is ‘manipulating’ its currency.”

Of course, all the above is a form of manipulation in common parlance, just not in a direction that would favor China running a larger trade surplus. In short, in 2018 China ran the smallest current account surplus relative to its own GDP in 25 years and it has recently spent about one-quarter of its foreign exchange reserves defending its exchange rate, so how can it possibly be manipulating its currency for an unfair trade advantage?

The IMF, for one, believes that the current exchange rate is more or less in line with the economic fundamentals and its view is important because it is through the aegis of the IMF that discussions are supposed to progress once a country has been designated a “Currency Manipulator”.

The argument against the recent action by President Donald Trump administration is current, specific, even legalistic, but perhaps misses the bigger picture. At the economic level, the Communist Party has kept tight control over the allocation of resources through the financial system and has retained ownership of State-Owned Enterprises (SOEs) that dominate the commanding heights of the economy.

Most pertinent to the debate about the exchange rate, China’s export success is a function of their state-led industrial policy including asymmetric market access. The paucity of imports for final consumption is a function of state induced saving at the expense of household expenditure, and the failure of the exchange rate to reflect the changing fundamentals of China’s economy reflects a capital account that is controlled on the way out and restricted on the way in.

In a planned state-led economy that is seen as an instrument for national aggrandizement, with economic objectives set by the Party to fulfill a political agenda, and where every aspect of the balance of payments is heavily influenced by Government policy, how can the exchange rate be anything other than a function of manipulation – direct or otherwise?

Current Account Surpluses

China’s designation as a current manipulator was removed in 1994, a year in which, following a 30 percent devaluation in the official RMB against the dollar, China’s current account swung from a deficit of $11.6bn in 1993 to a small surplus of $6.9bn in 1994.

The existence of the 1993 deficit and the small size of the 1994 surplus was a major factor in removing China’s Currency Manipulator designation, but it turned out that 1993 was to be the last year in which China ran a current account deficit.

Since then the surplus has totaled on a cumulative basis $3.4 trillion which for context is 7.5 times the size of China’s economy in 1994 and has averaged 3.2 percent of GDP over the entire 24-year period. For the seven-year period 2004 to 2010 inclusive, it averaged a whopping 6.5 percent of GDP, peaking in 2007 at 10 percent of GDP.

It took the global financial crisis and the destruction of demand in China’s chief export markets to bring the current account balance back down to earth but even the global financial crisis and the deepest recession in the West since the 1930s could not produce a current account deficit in China.

Foreign Exchange Reserves Accumulation

Between 1994 and 2013, which were the peak years of manipulation of the exchange rate if one chooses foreign exchange reserve accumulation as the measure of manipulation, China’s reserves grew by $3.85 trillion and there was not a single year in which they fell, even during the Asian financial crisis and the GFC.

Allowing for a 4 percent average return on the reserves  – the yield that China earns and which allows the stock of reserves to grow naturally even without additional purchases of Dollars or foreign currency – we can estimate fresh exchange rate intervention at about $3.1 trillion dollars over the period. That compares to a cumulative total current account surplus of $2.4 trillion over the twenty years.  In other words, the Chinese central bank was responsible for the recycling of about 130 percent of the current account surplus.

Why did they do this? In the absence of a rising nominal exchange rate, the rational, private sector in China was unwilling to sell RMB to buy foreign currency. The price was not right to bring the demand for buying RMB into line with selling from owners of RMB, and so the central bank had to step into the void, or the exchange rate would have appreciated. This is indisputably currency manipulation with the purpose of gaining an unfair advantage in trade.

One of the criteria given for China’s designation as a currency manipulator in 1992 was the rise in foreign exchange reserves to an equivalent of 10 months of imports and, one reason for removing the designation was the subsequent fall to just 5 months of imports.

By 1997 they had grown to reach 15 months’ worth of imports and the lowest import coverage ratio since then has been 11 months in 2000. They peaked at over 25 months’ worth in 2009 and even with the recent $1 trillion reserves drawdown, they stood at over 13 months’ worth in 2018. By this yard-stick at least China has been a “manipulator” since 1997 and remains so today.

Dual Exchange Rate System

The big change in 1994 was that the official exchange rate (RMB 5.8 to the US$) and the “market” exchange rate (RMB 8.7 to the US$) were brought into line – downwards, naturally. The result was a 30 percent fall in the official rate, but since many exporters were not using the official rate it is arguable if the real effective exchange rate depreciated as much as the headline suggests.

Outbound FDIConsider, for example, the drawdown in foreign exchange reserves from the high in mid-2014 to now. This can quite legitimately be presented as evidence that China is supporting the value of the Yuan through the actions of the PBOC, selling dollars to buy RMB to support the price.Consider also though, China’s “Go out” policy. This was officially announced in 1999 but outbound foreign direct investment from China to the rest of the world was very limited until recently. From negligible levels in the early 2000s, outbound FDI rose to an annual pace of about $60bn by the time of the GFC in 2008. It doubled from that level through to 2015 to about $120bn. By the end of 2017, Chinese State-owned Enterprises had amassed nearly $1 trillion of overseas assets through direct investment.

Looking at the drawdown in foreign exchange reserves in conjunction with the ramp-up in overseas assets owned by SOEs, to which should be added the overseas assets owned by “private” companies such as Huawei or Tencent, suggests that what was happening was really a portfolio shift. China was selling down some of its excessive stock of low yielding treasuries and other government instruments and acquiring overseas assets in the real economy through state-controlled companies.

This is perfectly rational, improving the yield on overseas assets by taking on more risk, but could give the misleading impression that it was engaged in a defense of the currency when arguably the PBOC was facilitating the sanctioned investments by SOEs and quasi-SOEs, many of which were geopolitically motivated.

Of course there was leakage, uncontrolled and unintended capital flight too, but the fate of companies such as Anbang, Wanda and HNA that were involved in overseas acquisitions that did not necessarily meet with the approval of the Party, is testimony to Beijing’s willingness and ability to tighten control of the capital account when required.

Access to the foreign exchange market on the way out in China is a privilege, not a right, and a breach of the rules constitutes an “economic crime”. Does such State control over the capital account make the RMB dollar exchange rate manipulated? Many would argue yes. The exchange rate certainly does not reflect the free, spontaneous and self-interested transactions of a deep pool of free economic agents, that much is certain.

The Challenge of Non-Market Economies 

This insight has argued that the US Treasury was wrong to remove the designation of Currency Manipulator from China in 1994. At the very least it should have been reimposed soon afterward. It was equally wrong, by their own criteria, to re-designate China as a Currency Manipulator in 2019, albeit correct to do so in a broader context.

So, what sort of changes to the criteria should be considered to make the process fair and consistent? The starting point is surely that China is not a market economy and as such, it will always manipulate its exchange rates in some way. The trading account and the capital account are a function of government policy, and that policy is as much to do with China’s geopolitical ambitions as it is to do with economics.

The Central Bank is not the only vehicle that can re-cycle current account surpluses at a non-market price; SOEs or sovereign wealth funds can do the same thing. A sustainable and equitable global trading system needs rules that take account of the vagaries of economies that operate outside the market system.

by: Stewart Paterson, Research Fellow at Hinrich Foundation, Asia-based Organization on Global Tade