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The US-Chinese Exchange Rate Controversy: A Deviant Case in North-South Monetary Relations? Matthias Kaelberer and Hongying Wang Between 1995 and the summer of 2005 China pegged its currency, the yuan or renminbi (RMB), to the U.S. dollar. China stuck to the peg despite strong US pressure for a revaluation over many years. While the 2.1 percent revaluation of the RMB on July 21, 2005 formally ended the peg very little changed in substantive terms. The revaluation was small and the subsequent appreciation of the RMB has been miniscule so far. De facto China is still keeping a lid on the upward move of the RMB against the dollar despite American pressure to change the policy. At best, the current situation can be described as a slow crawling peg. The recent US-China currency controversy raises an interesting analytical puzzle: Why has the U.S. been unable to prevail over China on its exchange rate policy? Or, to put it differently, what explains China’s successful resistance to American pressure for revaluation? Following conventional international political economy analysis, the United States is still a more powerful international player in the global economy than China. With respect to China’s exchange rate policy, however, it is the developing country that has clearly held the upper hand in the interaction. This is usually not the way monetary relations have worked between North and South in the past. Chinese-American monetary relations represent a unique opportunity to investigate the nature of monetary power. In addition to addressing the puzzle of monetary power, the paper reverses the analytical angle normally applied to exchange rate crises – in particular the crises between North and South. Conventionally, the international political economy literature examines downward pressures on weaker currencies of developing countries that result in the devaluation of these currencies – such as the Mexican peso crisis of 1994/5, the East Asian crisis of 1997/8 or the Argentine default of 2001/2. However, the literature pays virtually no attention to revaluation pressures. How do revaluation crises play themselves out as opposed to devaluation crises? Our contention in this paper is that this type of revaluation crisis is not simply the reversed of conventional devaluation crises. Most importantly, the interaction between dollar and RMB in this case obviously contradicts the typical relationship between strong and weak currencies: it is the currency of the presumably less powerful economic player that experiences revaluation pressures. Simultaneously, the dollar – despite its corresponding devaluation pressure – remains the largest reserve currency in the world and can still draw on an enormous reservoir of trust. Paradoxically, both China and the United States can maintain the current stalemate over the dollar-RMB exchange rate because neither one of them really faces a payments constraint – the United States can continue to create dollars and China can continue to accumulate them in their reserve holdings. The first section of the paper describes the functioning of the dollar-RMB peg and the American pressure for RMB revaluation. In this context we will compare the current imbalance between China and the United States to the historical experience of Bretton Woods. The second section of the paper explains China’s interest in pursuing an exchange rate policy that keeps the RMB closely tied to the dollar. There we will pay attention both to the international and domestic political factors that help explain Chinese policy preference. The third section of the paper discusses why China has been able to defy American pressure for revaluation. In doing so, we elaborate on the notion of monetary power. Power in the monetary sphere is based on more 2

than merely economic size. Most importantly we argue that monetary power is based on a country’s absence of a payments constraint. I. China’s Dollar Peg and American Pressure For more then ten years China has pursued a de facto unilateral peg of the RMB to the dollar (see table 1). Indeed, some analysts have started to describe the current situation as “Bretton Woods II” – a renewed pegged exchange rate system between the U.S. and several Asian currencies – most prominently, of course, China. 1 While the current system does not have the de jure elements of the classical Bretton Woods System, there are a number of intriguing parallels. A comparative assessment of “Bretton Woods I” and “Bretton Woods II” allows for a better understanding of the current macroeconomic interaction between China and the United States. Like the late stages of the Bretton Woods System, the current global situation is characterized by a deteriorating U.S. balance of payments position and depreciation pressure on the dollar. In the third quarter of 2005, the American current account deficit reached $783.3 billion at an annual rate – and stood at 6.2 percent of GDP. Meanwhile, the dollar depreciated from less than $0.90 per euro in 2002 to over $1.30 early in 2005. Several other currencies also appreciated vis-à-vis the dollar between 2002 and 2004. These depreciation tendencies arguably provided for some external adjustment to US balance of payments difficulties. The slight appreciation experienced by the dollar during 2005 vis-à-vis the euro and other currencies, appears to be due mainly to the temporary circumstances of interest rate increases in the United States, rather than any structural change in the U.S. balance of payments position. Table 1: RMB Exchange Rate vis-à-vis Selected Currencies End Period RMB per US$ RMB per € RMB per ¥100 RMB per HK$ 1994 8.6212 - 8.5130 1.0919 1995 8.3490 - 8.0703 1.0760 1996 8.3143 - 7.1633 1.0719 1997 8.2897 - 6.3627 1.0681 1998 8.2791 - 7.1919 1.0678 1999 8.2783 - 8.0933 1.0651 2000 8.2783 - 7.2422 1.0606 2001 8.2770 - 6.3005 1.0606 2002 8.2770 8.6360 6.9035 1.0611 2003 8.2770 10.3383 7.7263 1.0657 2004 8.2765 11.2627 7.9701 1.0637 06/2005 8.2765 9.9610 7.5149 1.0649 07/2005 8.1080 9.7778 7.1980 1.0422 08/2005 8.0973 9.8870 7.2970 1.0418 09/2005 8.0930 9.7593 7.1656 1.0430 10/2005 8.0840 9.8256 7.0197 1.0425 11/2005 8.0796 9.5453 6.7866 1.0416 12/2005 8.0702 9.5797 6.8716 1.0403 Source: State Administration of Foreign Exchange of the People's Republic of China 1 See, in particular: Dooley, Folkerts-Landau, and Garber (2003). See also: Dooley, Folkerts-Landau, and Garber (2004), Eichengreen (2004), Goldstein and Lardy (2005). 3

However, dollar depreciation has not been a universal trend. China, Hong Kong and Malaysia maintained their currencies in a peg to the dollar. Between 1995 and 2005, the RMB-dollar exchange rate stood at a central rate of 8.28 to the dollar. Japan, South Korea and other Asian countries did not pursue an explicit peg, but rather a managed float. In effect, however, Japan and Asia’s emerging market countries intervened heavily in financial markets in order to prevent a rapid depreciation of the dollar. Their efforts helped finance the US external debt through the purchase of US treasury bonds. 2 Thus, the primary reaction of all players to the existing balance of payments disequilibrium has been that of financing. In essence, the United States prints dollars, China and others buy them (see table 2). 3 To some degree, the current policies suit both American policymakers and their Asian counterparts. As long as China and others are willing to finance the U.S. deficit, authorities in both countries do not have to contemplate the costs of real adjustment. Financing is the politically most convenient option. However, as we will explain later, financing is not truly an adjustment mechanism to address underlying imbalances. Rather, it is merely a tool to bridge temporary balance of payments problems. Table 2: China’s Foreign Exchange Reserves End Period Foreign Exchange Reserves minus gold (US$ billion) 1994 52.9 1995 75.4 1996 107.0 1997 142.8 1998 149.2 1999 154.7 2000 165.6 2001 212.2 2002 286.4 2003 403.3 2004 610.0 2005 818.9 Source: State Administration of Foreign Exchange of the People's Republic of China http://www.safe.gov.cn/0430/tjsj.jsp?c_t=5 When it comes to the question of real adjustment, U.S. policymakers have shown a visible preference for external over internal adjustment, while ignoring the obvious connections between those types of adjustment. Some U.S. policymakers have tried in recent years to “talk down” the dollar – the so-called “dollar weapon” – and to convince Chinese authorities to let the RMB float upwards. 4 Members of the Bush administration and members from both parties of Congress have strongly voiced their preference for a revaluation of the RMB as a means to address the American balance of payments difficulties. Large portions of the public and the media have joined in a chorus putting pressure on China to revalue. 2 As Martin Feldstein (2006) points out, before 2000 the United States financed its current account deficit through the inflow of equity funds. Since there have been far less equity flows and the growing current account deficit has been increasingly financed by bonds and shorter term fixed-income funds. 3 China’s holdings of US dollars now equal about 30 percent of its GDP (Financial Times, January 9, 2006). 4 On the dollar weapon see: Destler and Henning (1989), Henning (1998) and Henning (forthcoming). 4

For example, Treasury Secretary Snow has heated up American rhetoric on the question of a Chinese revaluation. In May 2005, the U.S. Treasury issued a report that warned China to revalue the RMB, and hinted at possible retaliatory action by the United States if China would not let its currency appreciate. 5 However, it did not directly accuse China of manipulating the exchange rate. Instead, the report described Chinese policies as highly “distortionary”. In that sense, the Treasury attempted to walk a tightrope between angering China a angering Congress. Following the July 2005 RMB revaluation the November 2005 Treasury Report to Congress viewed China’s exchange rate policy as constricted. Thus, while the Treasury has voiced concern on this issue, it has been reluctant to propose specific punitive measures. Other policymakers have been more outspoken on this question. Some have promised coercive steps. For example, during his Senate confirmation hearings, U.S. Trade Representative Rob Portman argued that China does not always play by the rules and that some Chinese trade practices are illegal – including a deliberate undervaluation policy. He also promised a review of Chinese trade practices. 6 Debate in the U.S. Senate has been even tougher. The Senate provided unusually strong bipartisan support for the Schumer(D)/Graham(R) proposal to impose a 27.5% tariff on all Chinese exports to the United States to reduce China’s export advantage stemming from the RMB’s undervaluation. Both senators agreed to delay the vote on their bill only after receiving Treasury Secretary Snow’s promise to increase pressure on China for a RMB revaluation. 7 Given the fact that China’s revaluation turned out to be small and given the fact that subsequent appreciation of the RMB remained meaningless, the Schumer/Graham proposal is bound to return to the agenda if the status quo prevails. Table 3: US Trade With China: 1994-2005 All figures are in millions of US dollars Year Exports Imports Balance 1994 9,281.7 38,786.8 -29,505.1 1995 11,753.7 45,543.2 -33,789.5 1996 11,992.6 51,512.8 -39,520.2 1997 12,862.2 62,557.7 -49,695.5 1998 14,241.2 71,168.6 -56,927.4 1999 13,111.1 81,788.2 -68,677.1 2000 16,185.2 100,018.2 -83,833.0 2001 19,182.3 102,278.4 -83,096.1 2002 22,127.7 125,192.6 -103,064.9 2003 28,367.9 152,436.1 -124,068.2 2004 34,744.1 196,682.0 -161,938.0 2005 41,836.5 243,462.3 -201,625.8 SOURCE: U.S. Census Bureau, Foreign Trade Division, Data Dissemination Branch, Washington, D.C. 20233 The exchange rate debate, of course, has not been isolated from other factors. Clearly, the fact that the U.S.-Chinese trade imbalance doubled in just three years heightened 5 New York Times, May 19, 2005; Washington Post, May 18, 2005 6 Frankfurter Allgemeine Zeitung, April 25, 2005; New York Times, May 17, 2005. 7 FinancialTimes, July 24, 2005. 5

Washington’s concerns (see table 3). Continued stories of outsourcing by American companies and Chinese violations of intellectual property rights have increased pressure on policymakers. In addition, the dramatic rise in Chinese textile imports in early 2005 following the abolition of the textile quota system further highlighted the U.S.-Chinese trade imbalance. China was successful in reducing some of the pressure when it revalued the RMB on July 21, 2005 by 2.1 percent from 8.28 to 8.11 RMB/dollar. Simultaneously, the Chinese authorities announced what appeared to be a shift toward a managed float anchored not merely around the dollar but a currency basket. The RMB was allowed to fluctuate within a 0.3 percent band against a basket of currencies. In reality, of course, the RMB has moved very little. By the end of 2005, the RMB had just barely risen by half a percent against the dollar. At that pace, the RMB will not reach the expected 15-30% revaluation anytime soon. There was also little evidence that China pegged indeed to a basket of currencies instead to the dollar alone (Goldstein and Lardy, 2006). On the other hand, it is far from obvious that a depreciation of the dollar alone would solve the underlying issues. There is a significant debate about the potential effects of a Chinese revaluation on the trade balance. While some analysts predict positive effects on the American trade balance, others view the potential effects as minor. They argue since Chinese producers have huge cost advantages that would not erode unless there were a truly substantial change in exchange rates. Moreover, because China assembles a lot of imported material that gets turned into exported products, a revaluation would partially offset the presumed loss of competitiveness through lower import costs. As a result, price increases would be much more moderate than indicated by the revaluation rate. Moreover, even if RMB appreciation can reduce American imports from China, it will not shrink the overall trade imbalance of the US. As then-Federal Reserve Chairman Alan Greenspan argued, imports from China would merely be replaced by imports from other countries. 8 Although external adjustment and internal adjustment may appear to be alternative solutions to the balance of payment problem, in reality they are related. The American emphasis on exchange rate changes ignores the corresponding domestic side to the equation. A revaluation of the RMB would inevitably lead to domestic adjustment in both countries as well. The use of the “dollar weapon” carries the potential of shooting oneself in the foot. A dollar depreciation would be accompanied by higher interest rates, higher inflation or a combination of both. Instead of borrowing from abroad, the U.S. would have to reduce its private and public deficits. In other words, U.S. efforts to threaten its major creditor with sanctions resemble efforts to “bite the hand that feeds one” (Wolf, 2005). Regardless of the potential merits and policy consequences of a Chinese revaluation, the central analytical puzzle is the lack of success for U.S. policymakers in achieving this goal. Revaluation of the remnimbi is unambiguously a high priority of American policymakers. Except for the largely symbolic step of July 21, 2005, China has not budged. China’s defiance against US pressure requires analytical attention. The next section examines Chinese interests in this controversy. II. Explaining Chinese Policy Preference Why does China want to stick to the dollar peg? What are some of the major interests underlying its policy preference on this issue? Under what conditions might the Chinese government change its calculations? Given the closed nature of China’s decision making process, it is next to impossible to find direct evidence of policy makers’ calculations. As the next best thing, we examine the writings of Chinese policy analysts in the public realm, assuming they approximate and influence policy makers’ thinking. 8 Financial Times, May 21, 2005. 6

First of all, Chinese policy analysts believe RMB revaluation would slow down China’s economic growth. According to most observers, the continuous growth of the Chinese economy over the last 25 years has been based on two pillars – export and foreign direct investment (FDI). A significant RMB revaluation would dampen both. On the one hand, RMB appreciation would raise the price of Chinese export and reduce the competitiveness of Chinese products on the international market (Liu Yanhui, et al 2003). Surveys of Chinese export enterprises reveal widely shared anxiety over revaluation (Zhongguo Qiyejia, 2003). Furthermore, they argue, China’s success in international trade has benefited a great deal from a stable exchange rate regime. To remove that stability would inevitably shake an important cornerstone of China’s economic development (Hai Wen 2005). On the other hand, rising RMB would make China less attractive to FDI. This is not only because it would be more costly for potential investors to purchase Chinese factors of production, but also because many companies investing in China sell their products abroad. As Chinese export becomes less competitive due to its currency appreciation, they are more likely to move their operations to countries where production is cheaper than China (Liu Yanhui, et al 2003). These economic setbacks would have serious social and political consequences. As many of China’s most dynamic enterprises depend on export, a reduction of output in those enterprises would lead to rising unemployment. Given China’s underdeveloped social safety net, it would inevitably worsen the social turmoil and political instability that has already become a major political problem. According to the official Chinese estimate, there were 87,000 “public order disturbances” in 2005, a 6.6% increase from the year before. Indicative of the government’s worries is a report by two analysts in Jiangsu Public Security Bureau. It warns that RMB appreciation would cause serious difficulties for the province’s textile and other export-dependent enterprises, which would result in reduced profits or even bankruptcy. That, in turn, would create many more laid-off or unpaid workers, who would likely engage in massive protests and/or criminal activities (Liu Yibei and Lu Liping 2005). While the negative consequences would be widely felt throughout Chinese society, several sectors would be hit the hardest. Chinese agriculture is relatively inefficient by world standard. Over the last two decades, peasant income has been stagnant while the rest of the country has become richer. The gradual removal of protection under the WTO is exposing Chinese peasants to severe international competition. A RMB appreciation would increase agricultural imports at the expense of domestic products, further impoverishing Chinese peasants. Meanwhile, the greater availability of imported goods would mostly benefit urban groups. Juxtaposing the two likely trends, the result would be greater disparity between rural and urban residents (Wang Xiaomei 2004). Relatedly, Chinese policy analysts emphasize that the loss of price competitiveness of export would be especially devastating for China because it is a large agrarian society in the midst of transition. Export-oriented enterprises have been a major source of employment for the redundant rural labor. Their decline would certainly slow down and even reverse the process of urbanization in China (Li Li and Huang Liang 2004). Last, but not least, RMB revaluation would be particularly challenging for the state-owned enterprises (SOEs). China began to force the SOEs into the market place in the early 1990s. These reforms have been difficult even during the best of times. They would be even harder to carry out at a time of shrinking export and declining FDI. Many SOEs depend on international markets. And even more rely on the injection of foreign capital in the form of FDI (Li Li and Huang Liang 2004). In addition to these immediate economic considerations, some Chinese policy analysts point out that if the Chinese government gave in under international pressure, international investors would see the Chinese exchange rate as vulnerable to political dynamics, which would 7

make China less attractive as a destination for investment. Furthermore, once the RMB appreciates, it may not only discourage FDI from coming in, it could also encourage domestic enterprises to move overseas. In the long run, this would hollow out China’s industrial base (Pang Xiaolan and Zhang Yingchun 2004). A second set of concerns on the minds of Chinese policy makers have been the likely negative consequences of RMB revaluation for the country’s financial system. As international pressure mounts for China to end the dollar peg, international capital has built up great expectations for the appreciation of the RMB. In 2002 the “errors and omissions” item in China’s international balance of payment turned positive for the first time in 12 years, indicating a “reverse capital flight.” In 2005 the State Administration of Foreign Exchange recorded an inflow of FDI that was $22 billion more than what was recorded by the Ministry of Commerce. The gap suggests substantial unofficial capital inflows (Market News 2/26/2006). The rush of hot money into the country has led to rapidly rising real estate market in several major cities, especially Shanghai. It has even boosted China’s strictly controlled stock market and the market for art works. Chinese policy makers are weary that any move of the RMB would simply increase the expectations of further appreciation, and lead to more speculative capital inflow. As Central Bank Governor, Zhou Xiaochuan, states, “the more speculation there is, the less China can afford to revalue the RMB” (Zhang Rui 2005). Hot money is a threat to any financial system. Chinese policy analysts are especially anxious about its impact on Chinese financial system. They recognize that the Chinese system is underdeveloped and lacks effective regulation. It is thus vulnerable to the attack of international capital. The experience of neighboring countries during the 1997 financial crisis casts a dark shadow on their assessment of China’s ability to protect its financial security in the face to massive flow of hot money (Zheng Xiaohong 2004, Huang Ping and Zhao Mingxiao 2005). A financial crisis would have both short-term and long-term consequences. In the short run, a massive exodus of speculative investment in the wake of RMB revaluation would erode China’s favorable balance of payment, lead to a sharp downturn of the real estate market and the capital market, and cause the economy to shrink. These would cause serious social instability, as discussed above. They would also threaten the rule of the communist government, which has come to depend so heavily on economic performance and political stability for its legitimacy. For some analysts, revaluation would cause such grave uncertainties in Chinese financial system that China is better off facing the threatened 27.5% tariff increase on Chinese export to the US than letting the RMB appreciate. They reason that the costs of the former are known, but the costs of the latter are unpredictable (Hai Wen 2005) On the other hand, financial chaos would, in the long run, slow down China’s financial reforms and postpone the end of a fixed exchange rate regime. The Chinese financial system is inefficient and fragile. It is dominated by state-owned banks heavily burdened by non-performing loans. The stock market lacks transparency and discipline. The government has sought to improve the financial standing of state-owned banks by injecting funds and writing off bad loans. It has also tried to tighten the regulation of the stock market. But ultimately the solution will be privatization and market competition in the financial sector. This is a long process filled with potential pitfalls. If the fluctuation of the RMB leads to a financial crisis, it will undoubtedly slow down the reforms (Lan Jiping 2004). With regard to foreign exchange regime in particular, most Chinese analysts agree that as Chinese economy becomes more integrated with the global economy and as its financial market matures, China will move from a dollar peg to a more flexible exchange rate regime. Some explicitly predict that as China gradually but inevitably liberalizes its capital market, the country will have to float the RMB in order to maintain monetary policy sovereignty (Fu 8

Zhangyan 2004). A financial crisis in the near future would disrupt China’s orderly move toward a more flexible exchange rate regime, and ultimately delay the floating of the Chinese currency. Besides the impact on Chinese economy and financial system, Chinese policy makers are concerned about the international political consequences of RMB revaluation. To begin with, they are not happy to be told what to do under any circumstances. They are especially annoyed to be pressed to do something to solve someone else’s problems. Some analysts point out that the US owes its balance of payment problems to Americans’ low savings rate, massive consumption, and growing government deficit. For the US government to tell China to revalue the RMB in order to improve America’s balance of payment amounts to telling others to take pills in order to cure one’s own disease (Xiang Ming 2005). It is both absurd and annoying. Quite aside from the inherent logic (or the lack thereof) of a revaluation policy, the Chinese government would have to pay a heavy price for being seen as giving in to foreign pressure. In recent years nationalism has been on the rise. Although the government may have encouraged or even cultivated the nationalistic trend, it cannot turn off the public as easily as it has turned it on. The undercurrent of anti-American sentiment and the periodic outbursts of anti-Japanese furor that pervade Chinese society have created an environment in which the government finds it increasingly difficult to comply with international demands without provoking domestic discontent (Gries 1994, cf Zhao 2005). International demand has indeed backfired in this case. In a typical outcry, two authors warn “there is no way that China would behave by following others’ command! The determination of country’s exchange rate is the internal affair of a sovereign nation” (Chen Qiaozhi and Li Jingyuan 2004). More importantly Chinese policy makers are suspicious of the motivations behind foreign pressure for China to change the value of the RMB. Chinese analysts frequently compare US pressure on China today with US pressure on Japan in the 1980s. They argue that in the 1980s, when Japan was at the peak of its economic prosperity, Japanese export to the US far exceeded its imports from the US. Frustrated by the trade imbalance and threatened by the rise of Japan as an economic rival, the US twisted the arms of Japan and, through the Plaza Accord of 1985, forced Japan to let its currency to appreciate. The appreciation of the Yen slowed down Japan’s export and led to massive exodus of Japanese FDI to other areas in the world. It also contributed to the bubble economy within Japan. As a result of these developments, Japan has been stuck in a prolonged economic recession since the early 1990s. They suspect American pressure on China today is designed to achieve the same purpose – to get rid of another possible challenger and maintain America’s economic supremacy in the world. In 2003 the Party newspaper publisher, People’s Daily Press, published a book entitled Guard Against America’s Second Conspiracy, which draws an explicit parallel between America’s first “conspiracy” against Japan in the 1980s and its second one against China since 2002 (Wang Weixu and Zeng Qiugen 2005). In the eyes of the Chinese, international pressure for RMB revaluation seems especially cynical in light of international praise of China’s effort to hold the value of the RMB during the 1997 financial crisis. Interestingly, Chinese discussions of the international political aspects of the RMB controversy have focused not only on the US, but on Japan as well. Chinese analysts are keen to emphasize that it was Japan that first initiated the attack on China’s exchange policy. As early as 2002, Japanese Finance Ministry officials published an article in the Financial Times, accusing China of manipulating its currency and blaming China for economic problems faced by other countries. In early 2003 Japanese Finance Minister first raised this issue at the G-7 meeting. They observe that since then Japan has worked hard to “demonize” China and undermine China’s relations with other countries. They see Japanese policy on this issue as part of its 9

overall anti-China program. Like the US, Japan views China as a potential rival. The discourse of the so-called China threat has been as popular in Japan as it has been in the US. They believe Japan is determined to keep China behind itself economically by at least 20 years. Moreover, they argue that Japan seeks to discredit the RMB as a regional currency for Asia, and thus maintain the domination of the Yen in the region (Zu Jin 2003, Chen Huai 2003, Chen Qiaozhi 2004). From an international political perspective, some see American (and Japanese) demands on China to revalue the RMB as a component of an overall strategy to thwart the rise of China as a regional and a global power (Luo Binghua 2003, Zhang Shiming 2005). It is easy to understand why Chinese policy makers who believe in the conspiracy theory have been unwilling to comply with such demands. But others in the policy making circle have a more nuanced understanding of the American decision making dynamics. They notice a discrepancy between the American executive branch and the legislative branch of the government. In contrast to the Congress’s aggressive attack on China’s exchange rate policy, they observe, the Bush administration has taken a more low-key position and shown greater patience and flexibility. For instance, they note John Snow’s moderate tone on this issue during his visit to China in 2003 and Alan Greenspan’s testimony in front of Congress that even if China revalued the RMB it would not solve America’s balance of payment problems. They also take notice that the Treasury Department resisted Congressional pressure to label China as a currency manipulator. These analysts see the RMB controversy as a result of domestic political within the US. They oppose such politicization of the currency issue. Rather than Chinese capitulation to American politics, they argue the two countries should negotiate in a professional rather than political basis (Qiu Feng 2005, Zhang Bing 2005). Ironically, in arguing against revaluation, Chinese policy makers and analysts have relied in part on sympathetic voices in the West. For example, Robert Mundell, the Nobel Laureate and American economist, gave a speech at the China economic summit in May 2005, in which he laid out twelve reasons why the Chinese should not revalue the RMB. His argument has been widely cited in Chinese discussions on this subject. Other Western experts cited by Chinese opponents of revaluation include IMF’s managing director, Horst Kohler, and chief economist, Kenneth Rogoff, Harvard economist, Richard Cooper, and Stanford economist Ronald McKinnon, and Morgan Stanley’s chief economists Steven Roach. Although the voice against revaluation has been dominant in Chinese policy debate so far, there have been alternative opinions expressed. The minority in favor of RMB revaluation offer the following counter arguments in response to the majority. First, they don’t believe that revaluation of the RMB would significantly erode Chinese export. They calculate that the average wage of a Chinese worker is 2.1 percent of a Japanese worker and 2.2% of an American worker. A moderate or even significant increase of the value of the RMB would not chip away China’s cheap labor advantage. In fact, because Chinese export consists of high content of imports, a stronger RMB would actually reduce the costs of the imported components of Chinese exports (Zhang Xisong, 2004). Moreover, the flip side of reduced export competitiveness is increased import capacity. Some analysts see this as an opportunity for Chinese enterprises to increase their purchase of foreign technologies and equipment in order to upgrade their production (Liu Yanhui, et al 2003). More broadly, they are critical of China’s strategy of “exporting for foreign exchanges.” Under this strategy, Chinese enterprises would sell their products abroad at little or not profits in order to earn hard currencies. While it served useful purposes during the early years, when China experienced severe foreign exchange shortages, it is no longer sensible. China has the world’s second largest foreign currency reserves. It is no longer necessary to pile 10

up more foreign currencies at such costs. In fact, this strategy has become counter-productive. In the long run, they believe, China’s economic growth will have to come from domestic demands. As one of the world’s largest economies, China’s current dependence on export is excessive. This is both abnormal and harmful (Shi Liangping 2005). China’s management of foreign currency reserves has been inefficient. Mostly held in US treasury bonds, this massive amount of funds generates low yields. Meanwhile, China is letting in FDI that gets much higher rates of returns. The net result is a significant financial loss for China (Guo Hongxian and Li Xiaofeng 2004). On this ground, they view RMB revaluation as a possible turning point away from the export-oriented development strategy (Yu Yongding 2003, Wang Yunxiang 2003, Zhang Xisong 2004). As for the impact on FDI, they recognize that as Chinese currency rises in value, China may become less attractive to some foreign investors. But on the other hand, it will make foreign assets cheaper for Chinese buyers. Chinese companies can take advantage of this and greatly increase their investment abroad. This will give China control over much needed natural resources abroad and international R & D facilities (Pang Xiaolan and Zhang Yingchun 2004). Regarding the consequences of RMB revaluation on the Chinese financial system, they are less concerned about the prospect of hot money wrecking havoc than the danger of rising inflation. In recent years, the Chinese central bank has intervened in the foreign exchange market heavily, buying excessive foreign currencies and releasing large sums of RMB. To keep inflation down has required sterilization measures by the PBC (People’s Bank of China). However, sterilization is not sustainable in the long run. Continued inflow of foreign currencies through China’s current account surplus, FDI and hot money will ultimately lead to inflation. And inflation will lead to social instability (Zhang Xisong 2004). They see RMB revaluation as a first step toward a more flexible exchange rate regime. Politically, advocates of revaluation do not buy the conspiracy theory. Nor do they believe Japan’s bubble economy and the ensuing economic stagnation was a necessary result of the Plaza Accord. Rather it was due to bad policy choices by the Japanese government, enterprises, and financial institutions. Thus, if China carefully directs its economic policy after the appreciation of the RMB, it does not have to follow the disastrous path of post-Plaza Accord Japan (Zhu Jianyuan 2003). To the contrary, they view a stronger RMB as a symbol of a stronger China. It would improve the status of the Chinese currency, which in turn would raise China’s international prestige (Liu Yanhui et al 2003). They also think if China revalues the RMB, it will get credit for contributing to addressing the existing global imbalance. Consequently, China’s relations with other countries will be improved and its reputation as a responsible great power will be enhanced (Zhao Lan 2004). Overall, the argument for sticking to the dollar peg has enjoyed greater support among Chinese policy makers. This is probably because the costs of RMB revaluation are quite immediate, such as a decline of Chinese export and incoming FDI, the danger to financial chaos caused by massive inflow of hot money, and the “loss of face” for the Chinese government to give in to international demands. In contrast, the costs of sticking to the dollar peg are somewhat far off, including the lack of sustainability of China’s export-oriented development strategy, and the inefficiency of holding large sums of foreign currency reserves. The most likely factor that may change the balance of calculations is the prospect of sterilization failure leading to inflation, for inflation will threaten China’s fragile social and political stability. It is interesting to note that both sides of the argument stress that their policy proposal will improve China’s image. The opponents to revaluation believe that conceding to American demands would damage China’s prestige, while supporters of revaluation think by contributing to the “public good” of global payment balance would earn credit for China. The former group 11

is more concerned about government image in the eyes of domestic audience. The latter is more interested in its image in the eyes of the international community. So far, the former has held the upper hand. This discussion of Chinese interests explains why China prefers sticking to the dollar peg. But it does not tell us why China has been able to resist American pressure for RMB revaluation. In order to tackle this question, it is necessary to examine the nature of monetary power. III. The Nature of Monetary Power If the American interpretation were correct that China is essentially free-riding and selfishly gaining advantages from its undervalued currency, why is the U.S. unable to make China play by American rules of exchange rate cooperation? In some sense, the current China-U.S. interaction resembles similar episodes in post-World War II monetary relations. During the 1950s and 60s Germany and Japan used undervaluation of their currencies in order to promote export-led growth, as did South Korea and Taiwan in the 1970s and 1980s. However, in those cases, the US might have regarded undervaluation as an acceptable development and reconstruction strategy at American expense. With respect to China, the U.S. should have a strategic incentive to constrain China’s ability to pursue export-led industrialization at American expense. China is obviously far more likely to grow into a geopolitical rival than Japan, Germany, South Korea or Taiwan. Why has the United States been unable to achieve its objective of forcing China into revaluation? This question illustrates that monetary power is driven by factors other than the classic concepts that have been used to explain power and policy outcomes in international relations, namely the overall size of an economy or the relative strength of government’s incentive for particular policy goals. The United States is still the more sizable economic player than China. Its estimated $12.7 trillion GDP in 2005 still outweighs China’s $1.8 trillion by a ratio of about 7 to 1. Of course, measured in GDP per capita, the inequality between the U.S. and China is even more evident. Aggregate size would predict that the United States should prevail in its interaction with China. Frequently, analysts use the strength of a state’s incentive for a particular policy outcome as an alternative or supplementary explanation for policy outcomes in international interactions. For example, the fact that a small country such as North Vietnam was able to prevail in the Vietnam War against the far more powerful United States is often attributed to its strong incentive in winning the war, and the corresponding lack of will or interest on the part of the United States. Using strength of incentive as a variable to explain outcomes in the US-Chinese exchange rate game does not help much to solve the puzzle. As we demonstrated earlier in this paper, U.S. policy makers publicly demonstrate a strong incentive for devaluing the dollar. On the other hand, the Chinese policy circle shows some degree of ambivalence about the exchange rate issue. Overall, the strength of China’s incentive to avoid rapid revaluation is probably weaker than the American interest in devaluing the dollar. Given the size of the US economy and the strength of its preference, one should expect the US to get its way in the exchange rate controversy with China. The fact that this has not been the case so far indicates that monetary power works in a different fashion than power relations in other areas. In this section of the paper we develop an argument about monetary power, which sheds light on why China has been able to resist the heavy pressure from the US. While we accept some of the assumptions made in the contemporary literature on monetary power as the starting point for our investigation, 9 we contend that the emerging 9 For the literature on monetary power see most importantly: Andrews (2006a). 12

literature on monetary power does not yet provide sufficiently comprehensive guidance for our investigation of the U.S.-Chinese exchange rate interaction. In fact, some of the assumptions made in the monetary power literature lead us in the wrong direction. Randall Henning (2006), for example, argues that the United States can use the “dollar weapon” – a deliberate attempt to drive down the value of the dollar – in coercive fashion to extract policy changes from other countries in order to bring its balance of payments problems under control. Indeed, Henning views exchange rate coercion as the key to understanding the distribution of international monetary power and predicts that the United States will use the dollar weapon against China in the contemporary conflict. However, the dollar weapon is not a feasible option for the United States in its exchange rate interaction with China. As will be shown below, the logic of monetary interaction in this case favors a stalemate rather than US victory. Other contemporary contributions to the monetary power debate also do not provide much guidance for examining the current Chinese-American exchange rate interaction. Kirshner (1995 and 2006), for example, emphasizes the coercive potential of US dollar policy through such means as currency manipulation, monetary dependence or systemic disruption. These categories, however, do not provide an explanation for the leverage China has obviously had on exchange rate relations. Similarly, Benjamin Cohen’s (1998 and 2004) currency pyramid envisions the US dollar as the top international currency without a meaningful rival. On the other hand, he does not even mention China’s RMB anywhere in the ranks of the monetary hierarchy (Cohen, 1998: 116-118; Cohen, 2004: 14-16). Consequently monetary hierarchies do not provide us with explanatory leverage to understand the current Chinese-American exchange rate interaction. We seek to supplement the current monetary power literature by emphasizing an alternative conceptualization of monetary power. We argue that the key aspect of monetary power consists of a country’s absence of a payment constraint. In other words, powerful monetary actors are characterized by their ability to finance disequilibria in their balance of payments. This definition provides a unique angle on the contemporary U.S. – Chinese interaction. On the one hand, the United States can finance its balance of payments disequilibrium – despite a deficit – because its national currency continues to get accepted in the rest of world. On the other hand, China can finance because it experiences a balance of payments surplus and simply accumulates dollars. As a surplus country, China can live with the imbalance as long as it can avoid the spillover of its financing operations into domestic inflation. Only when sterilization is insufficient to prevent the spill-over of interventions into the domestic money supply does the government face the need to choose between domestic (i.e. reflation) or external (i.e. revaluation) adjustment. The recent very low inflation rates in China indicate that China has yet to reach its limit for sterilization (see table 4). The fact that neither player truly faces a payment constraint explains the perplexing exchange rate interaction between China and the United States. Table 4: China Consumer Prices (Annual percentage change) 1987-96 (ten year average) 11.9 1997-2006 (ten year average) 1.3 1997 2.8 1998 -0.8 1999 -1.4 2000 0.4 2001 0.7 13

2002 -0.8 2003 1.2 2004 3.9 2005 (projected) 3.0 2006 (projected) 3.8 Source: IMF World Economic Outlook 2005, Statistical Appendix, pg. 219. Financing a balance of payments disequilibrium, however, is not a durable solution. In the long run, real adjustment has to occur. It is clear from the public policy debate we reviewed earlier, that U.S. officials prefer dollar devaluation to outright domestic austerity measures as its best option to launch real adjustment. In part this preference reflects the hope of American policymakers that a significant portion of the domestic adjustment costs could be outsourced to China. Instead of export growth, China would have to emphasize growth in domestic demand. However, the American policy debate ignores the determination and the resourcefulness of the Chinese government not to give in on the exchange rate issue under external pressure. One of the ironies of the current Bretton Woods II situation is that China does not allow the U.S. to achieve the preferred devaluation of the dollar. The United States simply does not have the option to threaten a go-it-alone approach in order to solve its balance of payments problems. Continuing to demand a RMB revaluation will not lead to any measurable results any time soon. Indeed, it will most likely be counterproductive and strengthen Chinese resolve not to let the RMB appreciate too quickly. The American argument that a Chinese revaluation would be good for China is both patronizing and cynical. 10 It assumes that Chinese authorities do not know what is good for them and forgets about American responsibility for its own deficit situation. Moreover, by demanding China to let the RMB appreciate, the US ignores the costs of dollar depreciation for the domestic economy of the United States. Most obviously, dollar devaluation would entail a shift from domestic demand toward the American export sector. Simultaneously, however, this would have to be accompanied by some form of austerity measures – in the form of fiscal retention and higher interest rates. Instead of demanding a Chinese revaluation, the United States would approach its payments deficit more effectively by adopting measures to reign in domestic spending. Consistent with the argument presented in this paper that monetary power rests on the ability of the domestic economy to adjust, only addressing the domestic disequilibrium will allow the United States to restore some leverage to its monetary bargaining. A serious effort by the U.S. to launch domestic adjustment coupled with efforts to satisfy Chinese interests in advancing its international prestige – say, an invitation to China for joining a G-9 – might then serve as a path toward a negotiated agreement along the lines of the Plaza-to-Louvre-process during the 1980s. China would need the cooperation of other Asian countries as well if it does not want to carry the domestic costs of adjustment all by itself. Negotiations with other East Asian countries would assure that China would not suffer an excessive loss of competitiveness vis-à-vis its neighbors. Thus, a negotiated agreement between all parties involved is the most beneficial path toward a solution to the current macroeconomic imbalances in the international political economy. Conclusion Monetary power rests on a country’s absence of a reserve constraint. The current U.S. Chinese conflict over exchange rate policy is a stalemate because neither of the two countries faces a reserve constraint. The United States can continue to issue dollars despite a payments 10 On the aspect of patronizing see Persaud (2005). 14

deficit because others still trust the dollar and accept the currency. China accumulates many of these dollars because of its balance of payments surplus. While these types of interaction are rare, they are not unprecedented. Germany and Japan faced similar situations with the united States several times since the early 1960s. South Korea and Taiwan used an undervalued exchange rate in a similar fashion. South Korea, Taiwan and now China have arguably used this strategy with some success, there is little to suggest that this will durably change North-South monetary relations and become a universal tool to achieve trade advantages. First of all, as we predict, China will give up undervaluation as soon as inflationary pressures become too strong. Secondly, not all Third World governments can afford a strategy of deliberate undervaluation. Governments will have to feel strong enough to coerce their populations into domestic savings and into sacrificing consumption. Third, this strategy depends on the unwillingness of the U.S. government to make the necessary domestic adjustments through appropriate austerity measures. If U.S. governments engage in those types of policies, they will effectively foreclose this option for emerging market economies. What remains to be seen is whether they can achieve such adjustment without the devastating consequences of increasing protectionism, trade wars and global financial crises. 15

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Authors: Wang, Hongying. and Kaelberer, Matthias.

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