Is China a currency manipulator?

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 United States and its main geo-political 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 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. The criteria for determining if the exchange rate is manipulated must surely be different from those that might apply to a relatively market driven economy.

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 United States. It does not, however, run a large current account surplus relative to its own GDP – the threshold being 2% – 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 USD 4 trillion in June 2014 to USD 3.1 trillion. Given that the reserves earn a return of perhaps 3% per annum, the implication is that China has spent about USD 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 the Trump administration is current, specific, even legalistic, but perhaps misses the bigger picture. At the economic level, the Communist party has kept a 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?

China’s 1992-1994 currency manipulation

To proponents of the President’s current stance, China has a long history of currency manipulation, one that even opponents do not dispute in full. China was designated a “Currency Manipulator” during the period 1992-1994. A reminder of the reasons for that designation and its subsequent removal might be illuminating. According to the Government Accountability Office, the main reasons for the designation were: 1) China ran a bilateral trade surplus of USD 12.7bn in 1991, “second only to Japan”. 2) China ran a Current account surplus of 3.3% of GNP in 1990. 3) Foreign exchange reserves had risen to a level covering 10 months of imports. 4) There was continued devaluation of the official exchange rate. 5) There existed a dual exchange rate regime. And 6) There were pervasive administrative controls over trade.

The changes that facilitated the removal of the designation were: 1) The current account moved to deficit in 1993 and the 1994 surplus was small even though the bilateral surplus had grown to USD 25 bn. 2) Foreign exchange reserves had fallen back to 5 months of imports, a more defendable number in terms of ensuring a smooth functioning of trade without being mercantilist. 3) The dual exchange rate system was unified. 4) Both foreign funded Chinese firms and private sector Chinese firms were given access to the foreign exchange market for foreign currency.

Current account surpluses

Rightly or wrongly, China’s designation as a current manipulator was removed in 1994, a year in which, following a 30% devaluation in the official RMB against the dollar, China’s current account swung from a deficit of USD 11.6bn (2.6% of GDP) in 1993 to a small surplus of USD 6.9bn (1.2% of GDP ) 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 USD 3.4 trillion which for context is 7.5 times the size of China’s economy in 1994 and has averaged 3.2% of GDP over the entire 24-year period. For the seven-year period 2004 to 2010 inclusive, it averaged a whopping 6.5% of GDP, peaking in 2007 at 10% 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 USD 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% 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 (China does not release the data so we must guess) – we can estimate fresh exchange rate intervention at about USD 3.1 trillion dollars over the period. That compares to a cumulative total current account surplus of USD 2.4 trillion over the twenty years.  In other words, the Chinese central bank was responsible for the re-cycling of about 130% 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 (or unable, due to legal restrictions), to sell RMB to buy foreign currency. The price was not right to bring the demand for buying RMB (from exporters repatriating revenue or foreigners trying to invest in China) 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 (although in fact they were lower at about 4 months). 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 USD 1 trillion reserve draw down 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.

Trade deficits

The USD 12.7 bn bilateral trade deficit, that was cited as a reason for the “manipulator” designation in the early 90s, actually doubled from 1991-1994, but this did not constitute a barrier to the removal of the designation in 1994. Suffice to say that it has grown dramatically since then both in absolute terms and as a proportion of the overall total. The change is that the deficit is no longer “second only to Japan” and, according to the US census bureau, it stood at USD420bn in 2018 – 33 times larger than in 1991 and about 2% of US GDP.

Dual exchange rate system

What about the abolition of the dual exchange rate system? The big change in 1994 was that the official exchange rate (RMB 5.8 to the USD) and the “market” exchange rate (RMB 8.7 to the USD) were brought into line – downwards, naturally. The result was a 30% 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. Nevertheless, from a current account perspective it had the desired effect for China of turning a deficit in 1993 to a surplus in 1994 and China’s market share in exports grew dramatically in the subsequent years. While optimists viewed it as an indication of market reform (China was recognizing the reality of a market price vis-à-vis an official price), it could equally be seen as a devaluation aimed at invigorating China’s export-oriented growth model.  Perhaps it was both.

Offshore Yuan and other manipulation approaches

The introduction of the offshore Yuan (CNH) in 2010 has parallels with the dual exchange rate regime, although its objectives are very different. The CNH came into existence in an attempt to square the circle of a highly export-oriented economy unwilling to liberalize its capital account. Indeed, the institutional infrastructure that was built around control over the balance of payments and therefore the exchange rate remains very much in place: SAFE (the State Administrator for Foreign Exchange); CFETS (China Foreign Exchange Trading System) and the daily fix or “reference rate” for the Yuan are not exactly the kind of things one would associate with an unmanipulated currency. It is the State and Communist party control over the balance of payments that, for many observers, means that the objective criteria that the US Treasury report has used to exempt China from the manipulator designation in the post 2014 period are insufficient to capture the nuances of currency manipulation by an authoritarian regime running a state led economy. There is a veritable “alphabet soup” of anacronyms (eg: QFII, RQFI etc.) associated with the various ways in which access to foreign capital markets is restricted by the Chinse authorities and likewise for foreigners accessing China’s capital markets.

Outbound FDI

Consider for example, the draw down 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 USD 60bn by the time of the GFC in 2008. It doubled from that level through to 2015 to about USD 120bn. By the end of 2017, Chinese State-owned Enterprises (just those owned by the Central Government, not local governments) had amassed nearly USD1 trillion of overseas assets through direct investment. Looking at the draw down in foreign exchange reserves (USD 750bn between the end of 2014 and the end of 2018) 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 geo-politically 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 paper 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 afterwards. 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, because the trade account and the capital account are a function of government policy, and that policy is as much to do with China’s geo-political 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.

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