China`s Exchange Rate Policy in the Light of the German Experience with an Undervalued Deutschmark

This paper deals with the present undervaluation policy in China in the light of the German experiences with the undervaluation of the Deutschmark under Bretton Woods conditions. In Germany, there was a 20 years lasting academic and public debate on the needs for appreciation because of the high costs of having an undervalued currency. These costs referred, i. a., to inflation import, overheating the economy, and distortion of the internal production structure of the country – this seeming to be a similar situation in present China. From the German experience it is argued that flexible nominal exchange rates for large economies like China could better reduce the costs of the adjustment needs of real exchange rates than adjustments via internal inflation. Furthermore, if China as a new Global Player fulfills some necessary conditions for sound economic performance the RMB could possibly change the international monetary order towards a 3-polar monetary system.

1. China and the current undervaluation of the RMB

Exchange rate policy is one of the most important policy areas for a country. There is a long theoretical and empirical story about optimally shaping exchange rate regimes as a frame for the exchange rate management of individual countries. The international monetary order is, after the fall of the Bretton Woods regime in 1973, characterized by internationally no official intervention obligations of the national Central Banks, i. e., every country is free to choose its exchange rate strategy.

In this regard, China`s strategy apparently has been implying and still implies a policy of undervaluation of the RMB. Different views exist on the extent of undervaluation: Research estimates currently range from 10 to 25 %, dependent on different approaches as regards theoretical exchange rate models, types of exchange rates (nominal, real, effective), as well as econometrics and data reliability. There is no denying the fact that the external (balance of payment) and internal imbalances (overheating and inflationary pressure) of the Chinese economy are not independent of the undervaluation of the RMB.

The question is why the Chinese Government for long has been resisting official appreciation (though there now seems a general appreciation-affine change of exchange rate management to be installed by some kind of crawling peg).

Presumably, the following reasons are of importance: First, there has been and still is fear of contractive effects on employment and growth. This argument is based on the well-known textbook`s elasticity approach assuming that the Marshall-Lerner-Condition holds for China (elasticity optimism). It is, furthermore, based on the traditional balance of payments theory assuming that the current account balance dominates the capital balance which is – in the today`s world of increasing international capital flows – principally in question resp. an empirically false assumption at least if capital flows are not under political control. In this case, the current account balance is dominated by capital flows.

Secondly, the undervaluation policy implies accumulation of foreign exchange reserves by the Chinese Central Bank which might serve as insurance against a possible failure of the fragile Chinese banking system. And thirdly, accumulation of foreign exchange reserves could be part of a window dressing strategy of the Chinese government.

2. The undervaluation period in Germany

In order to learn from experiences, i. e. difficulties and mistakes, of other countries it could be useful for the Chinese monetary decision makers to study the German case of exchange rate policy during roughly 20 years (1952-1971) of undervaluation of the Deutschmark (DM). Under the Bretton Woods regime the member countries had to peg their currencies to the US-Dollar (USD) resp. to gold. Within a band of plus/minus 1% the currencies could float. Only in the case of a “fundamental disequilibrium in the balance of payments“ a country was allowed to realign its exchange rate.

After World War II and under Bretton Woods conditions, Germany realigned the DM several times. The exchange rates to the USD were fixed as follows: 1948 3,33; 1949: 4,20: 1961: 4; 1969: 3,66; 1971: 3,22. After the breakdown of the Bretton Woods system in 1973 the DM floated  to the USD in line with an appreciation trend.

Since the midst of the 1950ies, the “appreciation debate“ came up in Germany. It was a public debate which highlighted in 1957 and was followed by the first appreciation of the DM in 1961. The general discussion referred to the problem of more exchange rate flexibility which principally implies the question: To which extent should internal prices and the exchange rate share the burden of adjustment in case of an external disequilibrium and what should be the criteria for the adjustment sharing? This is the adjustment problem when there is need of real exchange rate changes.

The special debate on the undervaluation of the DM concretely focused, i. a., on four main topics:

• effects of accumulating foreign exchange reserves by the Bundesbank;
• increased inflationary potential through expansion of the monetary base;
• how to isolate from importing inflation ;
•  distortion of the production structure of the German economy: implicitly subsidized export and import substitution sector, implicitly taxed import sector.

The academic and public debate was especially launched by the newly established politically independent Council of Economic Advisers (CEA) in his first annual report (1964/65). The general recommendation  of the CEA was in favor of (more) exchange rate flexibility  which implied that the DM should rather appreciate more or less gradually instead of stepwise abruptly this being  detrimental for the economy because of the heavy implicit shock effects due to politically enforced expectation errors of the private investors and consumers.

It is interesting to know that the expertise of the CEA, not being in line with the Bretton Woods philosophy with its preference for fixed exchange rates, was also contradictory to the official view of the German government and of the lobbying representatives of the banking as well as the export and import substitution sectors. Nevertheless, the government lost election in 1969 due to, i. a., too much resistance against appreciation and more flexibility of the DM, and the first decision of the new government immediately after the election was to appreciate the DM.

The main arguments of the German CEA in favor of gradual appreciation (crawling peg) of the DM were focused on fighting inflation: As the German inflation rate, on average, was steadily and significantly below those of the important trading partners an undervalued DM implied not only an inflation import via trade balance surpluses but also via the direct international price coherence.

Thus, the Bundesbank should be dispensed from Bretton Woods intervention obligations vis-à-vis the USD and should guide its exchange rate policy principally along the inflation differentials between Germany and abroad. Therefore, pre-announced appreciation rates of the DM per month or quarter of a year should be combined with a pre-announced Central Bank policy as regards the money growth rates which could help stabilize the exchange rate expectations of the public and demotivate speculation.

This was a strategy of isolating the economy from inflationary pressure coming from outside the country. Furthermore, dispensing the Central Bank from obligatorily buying foreign currency in exchange to high powered money could stop the inflationary effect of too high growth rates of the money supply inside the country and/or could reduce the need for a monetary neutralization policy which would be more costly than would be exchange rate adjustments.

3. German-Chinese similarities?

The question arises whether there are similarities of past Germany to present China. No doubt, there are: Undervaluation of the nominal exchange rate, accumulation of foreign reserves, balance of payments surplus, export driven overheating the economy, real exchange rate adjustment (mainly) through internal prices, need for monetary neutralization policy (Germany: capital export oriented swap policy of the Centralbank, China: sterilizing Open Market Policy), distortion of the country`s production structure through undervaluation.

There is no need to explain that and why overheating the economy and inflation – both being complementary to a certain extent – are costly for any economy on various serious grounds. Furthermore, also sterilizing monetary policies are not without costs. Appreciation of an undervalued currency could act as a remedy to reduce these costs (despite the fact that also exchange rate changes are not free of charge).

This is also true regarding the problem of distorting the production structure. The undervaluation implicitly subsidizes the export as well as the import substitution sector of the economy and implicitly taxes the import sector. In this sense, undervaluation means protection. This means that the export and import substitution sectors are relatively too large, whereas the import sector is relatively too small in comparison to their equilibrium size. This misallocation of resources resembles old times of costly mercantilism. Furthermore, this misallocation necessarily implies serious distributive effects. These imply, i. a., higher RMB-prices for agricultural products because these products are invoiced in USD.

If undervaluation holds on for a longer time the opportunity costs of a distorted production structure of the economy are increasing, i. e., the costs of endogenously reshaping the economy when the exchange rate is moving towards equilibrium – which sooner or later cannot be prevented due to world market forces and pressure of the trade partners – will rise and so will then the political resistance to appreciation of the currency: A costly vicious circle which could be avoided by topical adjustments of the exchange rate. At least, this was Germany`s costly experience which could be of high relevance for (re)shaping China`s exchange rate policy today which, in fact, seems to become politically realistic.

4. Some theoretical aspects of alternative exchange rate policies

The theoretical and empirical literature on pros and cons of alternative exchange rate policies – fixed and flexible exchange rates, crawling pegs, managed floating, currency boards etc. – is boundless. Here is not the place to review them. Nevertheless, there has been coming up the discussion about corner solutions implying only the extreme alternatives: totally freely flexible or irreversibly fixed exchange rates. Corner solutions are recommended to avoid the mistakes of combining the disadvantages of not totally freely flexible and not totally irreversibly fixed exchange rates. Insofar, they are contradictory to the somewhat traditional view that a combination of elements of fixed and flexible exchange rate regimes would rather combine the advantages instead of disadvantages of both regimes. The empirical evidence shows that under certain conditions corner solutions can promote stabilizing expectations and, thus, reducing destabilizing speculation. Furthermore, corner solutions are recommended within cost-benefit analytical approaches of exchange rate adjustments.

The choice of corner solutions depends, i. a., on the size of the economy. The general recommendation is that large economies should practice freely flexible exchange rates whereas small countries should irreversibly peg their currencies to a stable key currency or currency basket. The question is why, and the answers are manifold. Some of them are pointed out here:

If there is need for real exchange rate changes of a currency the adjustment burden should principally not be carried entirely by the internal price vector of a country.  In case of appreciation needs, internal appreciation means increasing the price level, i. e., inflation, but internal inflation is detrimental. Therefore, the adjustment burden should be put heavily on the nominal exchange rate. Especially big countries like China profit from doing so because they reduce adjustment costs. Why? Instead of adjusting millions of internal prices of goods and services only one external price has to be adjusted: the nominal exchange rate. This implies, of course, the price adjustments of the tradable goods sector.

Increasing internal prices refer – more or less – to the prices of nontradable goods because the prices of tradables are dominated by the international price (and productivity) coherence. Thus, in a Balassa-Samuelson context, internal inflation as a substitute for currency appreciation implies inflation mostly in the nontradable sector, i. e., this sector has to bear the main adjustment burden of the need for a real exchange rate appreciation, generating serious distributional effects for consumers and investors within the country.

According to small economies, the recommendation to irreversibly peg their currencies to a stable key currency which could act as a stability anchor aims at submitting to the monetary policy of a stability oriented foreign Central Bank and, thus, importing its stability, reputation, and credibility. This strategy has been followed by many Central and Eastern European Countries (CEEC) which – if not joining the Euro-area – peg their currencies mostly to the Euro. These pegs are often enough arranged as currency boards with nearly no autonomy for a discretionary monetary policy of the Central Bank at home. Currency boards have been successful especially in countries which suffer from high inflation after replacing central planning by markets.

5. Conclusions for China`s exchange rate policy

What are the conclusions for China´s exchange rate policy? The German many years of experience with an undervalued DM are detrimental. They reveal that an undervalued currency may help an economy to take off for export driven growth in the beginning of a development process. But this policy could be beneficial only temporarily. In the medium and long run it is highly costly because of the high economic adjustment costs pointed out above.

China is facing significant needs for real exchange rate adjustments. In a dynamic globalizing world this will be true also in the future. China is – in the long or even medium term – confronted with threatening inflationary pressure from Asian and Arabian countries, also from the USA and Europe because of their present monetary easing policy. Therefore, for China it is necessary to isolate its economy from importing inflation. As a big country it should do this by adjusting the nominal exchange rate of the RMB rather than pegging (e. g. with the actual band of +/- 2 %) the RMB to the USD resp. to a currency basket (the currency weights of it not being disclosed) below equilibrium in combination with foreign exchange market interventions and costly sterilizing monetary actions to keep the internal inflation low (which is not sufficiently successful). And China should be aware of the fact that a too long period of undervaluation of the RMB results in a serious distortion of the country`s production structure which – because of world market forces – necessarily calls for costly reshaping in the future.

Therefore, China should principally take over the exchange rate philosophy of the USA resp. of any key currency of a Global Player: benign neglect, i.e., the the RMB should float with principally no Central Bank intervention target. At most, allaying too high exchange rate volatility might be sensible but no “leaning against the wind“-strategy. This philosophy – which in the past was underlying the official exchange rate policy also of the European Central Bank (ECB) but regrettably has now been changed towards exchange rate manipulating in the direction of Euro-depreciation in consequence of the monetary easing ECB-policy – implies that the exchange rate is seen neither as a mean nor as an end. As a relative price of two currencies resp. two monetary aggregates it is the resulting price of a complex portfolio of political-economic variables. This is true regardless of the institutional frame of an economic system. A flexible exchange rate is a good indicator for the expectations of the world –especially capital – market participants according to their views on the relative political-economic performance of any country. Making the RMB flexible could also serve as a first step to liberalize China`s capital account.

One could try to identify the future world monetary order. Therefore, it is useful to study the prerequisites for becoming a key currency or at least a dominant currency in the world. Four conditions should be fulfilled: The country should be economically highly competitive (Global Player), the economy should be large so that the monetary aggregates are large, the Central Bank should unconditionally and successfully aim at monetary stability, there should be internally and externally open markets in an institutionally trustable frame of a market economy.

At present, the world is characterized by two dominating currencies: USD and Euro. The RMB may have the potential to push the world monetary order into a 3-polar system with the RMB as the third dominating currency to which especially Asian currencies are going to dock if the Chinese political and economic system is restructuring in the above mentioned direction of success. China is on the way to pursue an active policy by propagating to invoice especially the inter-Asian trade in Yuan leaving out any vehicle currency. To attack the USD as the most important vehicle currency in the world the Chinese Government has been opening institutional opportunities to directly exchange foreign currencies into Yuan and vice versa on official foreign exchange markets outside Asia like Frankfurt, London and others. To make the strategy of China becoming a Global Player of a third world key currency, a flexible RMB could be a first important step.