Tokyo: A spectre is haunting China’s exchange rate regime: the long-running dispute between the US and Japan throughout the 1980s and early 1990s over the value of the yen. That dispute ended only when Japan’s economy entered its “lost decades”, which has made the Chinese determined not to repeat the experience.
Of course, history—particularly financial history—never repeats itself exactly. But the arguments being heard about the renminbi today certainly give rise, at least for Japanese, to a strong sense of déjà vu.
Now, as then, the US Congress is the focal point of American anger. Today, it is preparing retaliatory legislation against China in response to pressure from many in the US who argue that an artificially weak renminbi is contributing to global imbalances, in particular to the US’ massive bilateral trade deficit. They are also frustrated that the US treasury has not “named and shamed” China by designating it a currency manipulator.
But, based on Japan’s experience, the Chinese do seem to have good reasons to be wary of US pressure to revalue the renminbi. Indeed, the economists Ronald McKinnon and Kenichi Ohno have singled out US pressure for yen appreciation as a key source of the Japanese economy’s long-term deflation and stagnation—the so-called “lost decade” of economic malaise that is now well into its second.
The US and China have engaged simultaneously in dispute and dialogue for several years—again reminiscent of what Japan went through with the US in the 1980s and 1990s. Just as China has its “Strategic Dialogue” with the US, so Japan had the “Structural Impediments Initiative” (1989-1990) and “Framework Talks” (1993-1995).
And for China now, as for Japan then, the undercurrent for these discussions is US frustration with bilateral current account deficits. Both structural factors and the exchange rate are discussed. But the weight given to the exchange rate is higher today in the US-China dispute, because, whereas Japan had a “managed float” exchange rate regime in the 1980s and 1990s, the Chinese exercise much tighter control over the renminbi.
Chinese officials agonize over the US pressure. If they yield to it, the Chinese economy, they argue, may fall into the same deflationary trap that ensnared Japan after the yen’s appreciation in the 1980s—under US pressure—inflated a catastrophic asset-price bubble. But if they continue to resist, China may face hot trade disputes with the US, which could be even messier.
Like Japan in the 1980s, China must defend itself from US claims that the renminbi’s weakness is the source of the imbalances between the two countries. Currency appreciation, Japan argued then and China argues now, is unlikely to result in a significant current account adjustment, which requires addressing not only China’s high savings rate, but also low savings in the US.
How the situation will develop in the near future can be gleaned from the recent past. China instituted a flexible exchange rate from July 2005 to the summer of 2008, and the renminbi gradually appreciated against the dollar—cumulatively by more than 20%. Whereas the peg to the dollar was resumed during the global financial crisis, in June China announced a return to flexibility. The renminbi fluctuated without a clear trend until mid-September, when it appreciated sharply, apparently in response to increased US pressure stemming from the impending Congressional vote.
In one respect, then, the dispute appears set to follow a path similar to the US-Japan case. It will be prolonged and occasionally very tense, but eventually result in appreciation of the renminbi. But there is a crucial distinction to be made between the two cases: Japan needs the US to ensure its security, while China does not. Moreover, the size of China’s economy will surpass that of the US in about 15 years. So time is on China’s side.
But there is a more fundamental issue: the Chinese authorities, in arguing that it was a mistake to allow the yen to appreciate, may be misinterpreting what happened in Japan—and thus overestimating the risk posed by currency appreciation.
For Chinese officials who believe that yen appreciation was the source of Japan’s chronic economic malaise, the Plaza Accord of September 1985—a concerted effort by the US, the UK, France, West Germany, and Japan to depreciate the dollar—is Exhibit A. The yen soared from 240 to $1 in September 1985 to 200 to $1 the following December.
The real dilemma for Japan arrived in March 1986, when the yen neared its then record high, 178 to $1. Japan responded by intervening in the opposite direction—dropping interest rates, selling yen, and buying dollars. That proved decisive. Keeping interest rates low discouraged capital inflows and encouraged asset-price inflation.
The ensuing bubble in Japanese housing and equity prices inflated and burst not because Japan succumbed to US pressure to allow the yen to appreciate, but because Japan, in the end, resisted that pressure. So, if China is to draw the correct lesson from the Japanese experience, it must know what really happened in Japan back then.
What China should be carefully watching is whether there is are signs of overheating in the domestic economy, and whether asset prices are rising sharply. Allowing the renminbi to appreciate would be a good way to prevent both.
Takatoshi Ito, a former deputy vice-minister of finance for international affairs in Japan, is a professor of economics at the University of Tokyo.
Comments are welcome at firstname.lastname@example.org