Currency manipulation is a country’s practice of artificially devaluing or inflating its own currency, so that the exchange rate between that currency and others around the world is different than what it ought to be in a free market. This imparts a cost advantage to the exports of the currency manipulator, because their goods suddenly become cheaper on the global market relative to other countries’ exports. In an open economy, exchange rates should adjust to trade balances, so that as capital accumulates, demand for local currency would drive up its value. In other words, China’s surpluses should lead to an appreciation of the yuan, eliminating their pricing advantage.
But China doesn’t play by such normal rules. According to prominent national economist Paul Krugman, China uses its trade surpluses to constantly print more of its own money, flooding the market with Chinese yuan and creating demand for American dollars. At the same time, it uses its newly-printed currency to aggressively purchase US dollars and government debt; as of December 2012, China held over $1.2 trillion dollars in US-specific debt and had acquired a massive imbalance of over $3.4 trillion in foreign currency reserves.
Until June 2010, China actually dictated the value of the yuan against the value of the dollar, in essence “pegging” the worth of the yuan relative to the dollar at a ratio of 6.8 to 1. Although China has abandoned this hard peg, the Peterson Institute for International Economics still estimates that China undervalues its currency by up to 40%.
So what does this mean for the United States?
First, it means the distortion of competition. Because currency manipulation makes Chinese goods cheaper relative to those of the US, it also makes American products proportionally more expensive for Chinese citizens to import. Every business day, American consumers buy $1 billion more in Chinese goods than American manufacturers sell to China, which fuels the same kind of trade imbalance that fuels China’s currency manipulation in the first place. Indeed, the Economic Policy Institute estimates that were China’s currency to experience a full revaluation, the U.S. trade balance would improve by up to $191 billion, thereby increasing U.S. GDP by as much as $286 billion, adding up to 2.3 million U.S. jobs, and reducing the federal budget deficit by nearly $1 trillion over 10 years.
Second and more importantly, Chinese currency manipulation translates into the potential for real economic disaster. US dependency on foreign savings exposes our economy to certain risks, but China’s distasteful currency practices only make this truth harder to swallow. According to the New York Times, China’s amassment of trade surpluses is “the most distortionary exchange rate policy any nation has ever followed. Most of the world’s largest economies—the US included—are stuck in a liquidity trap as a result—deeply depressed, but unable to generate recovery by cutting interest rates because the relevant rates are already near zero.” In effect, China’s unwarranted surplus policies have imposed an anti-stimulus that the world’s economies can’t offset. Their artificially under-valued currency is more attractive to businesses and investors than the capital that US banks are reluctant to lend, which siphons demand away from domestic consumption.
While this may just sound like a lot of theory, the unfortunate reality is anything but. Many scholars, including Wayne Morrison of the Congressional Research Service, believe that China’s purchasing of US securities—the predominant mechanism by which China manipulates its currency—was a major contributing factor to the 2008 sub-prime mortgage crisis and subsequent global economic slowdown. “Such purchases kept real US interest rates very low and increased global imbalances,” Morrison argues. As China continues to buy up US debt to fuel its enormous expansion, the American-Chinese deficit only becomes more pronounced, and the scales are further tipped toward the prospect of future asset bubbles and distortions.
Yet the United States isn’t the only nation that languishes beneath China’s currency devaluation. Surprisingly, China’s economic policies have created distortions within the Chinese market itself. On the surface, China appears to be thriving, a competitive economic player in the global exchange—so competitive, in fact, that the Council on Foreign Relations predicts that China’s GDP will eclipse that of the United States in five to ten years. But sustained growth of such enormous magnitude and duration comes at a price, particularly given Beijing’s centralized economic governance structure.
China reserves large parts of its markets for state-owned enterprises, demanding that its government firms dominate industries such as coal and railway infrastructure—these industries can’t go bankrupt. Indeed, the Heritage Foundation observes that state-owned banks control as much as 90% of China’s assets. With such a tight rein on the economy, the Chinese government has unintentionally created a structural distortion in China’s central monetary practices, one that is only magnified by currency manipulation.
Analysis from a study published by New York University’s Stern School of Business notes two distinct mechanisms by which China’s banking practices and central domination destabilize the Chinese economy.
First, it creates an insurance effect on banks. Knowing they can’t become insolvent, bankers become more sensitive to loan volume than to the risks of those loans, which encourages risky lending practices. As loans are given out below the efficient rate, increased demand in the housing sector causes an aggregate increase in borrowing, which increases prices in the real sector above their fundamental value and creates a bubble.
Second, as banks allocate fractions of deposits from savers into the housing sector, they may face interim deposit withdrawals or draw-downs on corporate lines of credit. In this case, unable to meet their liquidity shortfalls, banks are forced to sell assets at short notice or raise equity in the markets, incurring a liquidation cost. And since private Chinese investment and consumption is inversely proportional to the demand for American dollars created by currency manipulation, banks are forced right back to the risky loans incentives that produce the aforementioned economic bubble.
The end result of this economic mess? Massively escalating debt. By China’s own estimates, total local government debt amounts to $2.2 trillion, or around one third of total GDP. Kenneth Rogoff of Harvard University furthers that waves of municipal defaults could present even greater problems for the central government, which is sitting on another $2 trillion debt of its own. On top of that, total corporate, public, and household debt in China totals to about 206% of current GDP. This debt spurs a vicious cycle, whereby China manipulates its currency—and thereby attracts foreign trade and investment—to cover its own economic inefficiency, but this short-term growth produces unsustainable long-term damage.
This sort of economic situation has happened before—China isn’t the first Asian nation to employ currency manipulation in order to rapidly create a booming industrial economy while at the same time producing artificially high growth rates. Japan tried the same thing decades earlier, but crashed in 1990; South Korea, which copied Japan’s developmental practices, experienced its own meltdown in 1997. Indeed, the phenomenon is so common among rapidly expanding East Asian countries that Time Magazine has referred to the situation as the “Asian Developmental Model.”
Under these circumstances, firms rely on heavy-handed direction and subsidization by the state in order to create massive industrial growth. Credit is made cheaply accessible to these firms, which funnel money—both private and public—into government-controlled operations, all while the state continues to reproduce conditions that make local goods attractive (in China’s case, currency manipulation). The problem is that prices can’t stay wrong forever. State-owned companies don’t have to show the same kind of capital returns that private companies do, leading to bad investments and heavy borrowing. Under this pressure, banking sectors buckle and investment bubbles explode. If China continues on its current path, there is a very real possibility that it will become another data point in this economic model.
Is China’s economic collapse looming on the horizon? No one can say for sure. But China’s subsidization and investment through currency manipulation amounts to around 50% of its GDP, unprecedentedly high even for the Asian Developmental Model. As China continues to explore its role in the global marketplace and the global community, it would do well to remember the limits of economic centralization, painfully exposed with the fall of communism in the 1980s. The economy of tomorrow is dependent upon the cooperation of all its players; in the game of globalization, China’s conduct may earn it three strikes and an out.