Ifo Viewpoint No. 119: Currency War – The Guilt is not China’s Alone

Hans-Werner Sinn
Munich, 2 November 2010

Since China pegged its undervalued currency to the dollar, every devaluation of the dollar in the wake of the American financial crisis has also meant a devaluation of the Yuan vis-à-vis the other world currencies. The central banks of South Korea, Brazil, Taiwan, Japan, Switzerland and many other countries are buying dollars in order to protect their own currency against a revaluation and to defend their exports. Europe also became nervous after the euro exchange rate had risen to more than 1.40 dollars, far beyond the purchasing power parity of 1.17 dollars.

The United States is now taking drastic steps against China and is making provisions for a trade war. Congress has authorised the President to impose import duties on Chinese products if China is not willing to increase the value of its currency substantially over the dollar.

Why is the US now suddenly acting so aggressively, given that the undervaluation of the Yuan, which is currently 45%, has already persisted for many years? Why did they not take action much earlier? The reason lies in capital movements. China is no longer willing to invest its income from merchandise trade with the US in American government bonds. The lower valuation of the Yuan was accepted by the Americans as long as China returned the dollars it earned to the US to finance the government deficit. Now that the Chinese prefer to invest their money in raw materials in Africa and elsewhere, they have aroused the full ire of US policy-makers.

The Chinese turnaround is indeed dramatic. In 2008 and 2009 China purchased US government bonds to the tune of 17 billion dollars a month. Since November 2009 China has reversed its course. On average for the first seven months of 2010, China has not only refrained from buying any more papers but has even begun to sell those it holds. Each month China sold a net amount of about 7 billion dollars in government bonds. That nerves are now on end in America is perfectly understandable.

London City has jumped into the breach, raising its purchases, which in 2008 and 2009 had only amounted to about 1 billion dollars monthly, to an average of 28 billion dollars in the first seven months of this year. Since the UK itself is a large capital importer, we can assume that the City is not holding the papers itself but merely restructuring them and then selling them to the world under a new name and with the London stamp on them.

Despite having withdrawn from financing the US government, China is still the world’s largest net capital exporter, followed by Germany, having held this position since 2006. Before the crisis, it exported about 400 billion dollars of capital annually, on average for 2007 and 2008. The US, which at the time needed annual capital imports of 800 billion dollars in order to offset the near total cessation of private savings, received the lion’s share of this capital. The unwillingness of the Chinese to consume enabled Americans to build new houses for many years on borrowed money and to maintain a level of consumption that its own economy was not able to finance.

To be sure, the Chinese always restrained themselves from private real-estate financing in the US. They only bought government papers and securitised real-estate instruments that were issued by the semi-public bodies Fannie Mae and Freddie Mac. The direct real-estate finance via private channels came mainly from other countries, Germany for example. Nevertheless, China helped the US achieve a higher standard of living by making money available to government authorities that would otherwise have had to come from American citizens themselves.

It is a little bit shabby now to reproach China for its exchange rate policy, since it was this policy that was the basic prerequisite that enabled the US to live beyond its means for so long. The low valuation of the Yuan was certainly not at the expense of the US, as is constantly claimed, but was the basic prerequisite that Americans were able to live the American dream of everyone being able to afford their own house. The imports of inexpensive Chinese products freed up in the US the capital and the workers that were employed for a dramatic expansion of the real-estate stock and the American standard of living.

It is understandable that the Chinese are now reluctant to invest more money in the US. They tried to enter the American energy market with the purchase of Unocal, but this was blocked by politicians. Other direct investments were also stopped by Congress under the pretence of national security. One need only recall the bidding for Emcore or Firstgold. The US indeed wanted the Chinese money, but it was not prepared to offer anything more than structured securities of questionable creditworthiness as well as government papers that are now clearly exposed to the risk of inflation and devaluation.

It would be a service to world peace if the US stopped making cheap moral accusations against China. The truth is often much more subtle than that which is maintained in political interests.

Hans-Werner Sinn
Professor for Economics and Public Finance
President of the Ifo Institute

Published by Project Syndicate (www.project-syndicate.org), 22 October 2010; additionally printed in Börsen-Zeitung, 26 October 2010.