Why China gains from yuan revaluation

PUBLISHED : Monday, 29 March, 2010, 12:00am
UPDATED : Monday, 29 March, 2010, 12:00am

Many believe that if China revalues the yuan, with US$2.5 trillion in reserves, it will lose US$25 billion for every 1 per cent appreciation of the currency. One rather excitable English economist at a Shanghai university even claimed that this loss would represent an equivalent profit to the US government.

These views are wrong - the latter almost comically so. In fact, it is difficult to say if China as a whole will benefit or suffer from an appreciation, but it is more likely it will gain rather than lose, because of the resulting improvement in the terms of trade as it gains more imports in exchange for every unit it exports.

To understand why, we must note that by definition an appreciation of the yuan automatically benefits everyone who is effectively 'short' foreign currency, and hurts those who are 'long'. Of course, the People's Bank of China will suffer a large loss if the yuan revalues. After all, to support its foreign-currency reserves, it has an equivalent amount of yuan liabilities, and a revaluation would cause the value of the yuan liabilities to rise relative to the foreign-currency assets.

But the nation overall doesn't lose. The real value of the reserves is not their value in yuan but rather in the sum of 'stuff' that can be bought with those reserves. As a revaluation reduces the yuan value of the reserves, it also reduces the yuan cost of foreign goods. China could buy as much 'stuff' with its reserves after it revalued as it could before.

Will anyone else besides the central bank lose if the yuan is revalued? Yes. In fact, every economic entity in China with a similarly mismatched balance sheet will also lose.

Exporters earn dollars while their costs are largely in yuan, and a revaluation immediately causes them to lose. Chinese companies and individuals who have stockpiled large inventories of commodities will also lose, since the values of those commodities are set in international markets, and a revaluation of the yuan immediately causes the value of those commodities to fall in yuan terms. Wealthy mainlanders who hold large amounts of money offshore will see their money value fall.

With so many losers, there must also be an equivalent amount of winners. The biggest group of winners by far consists of anyone who is a net importer of foreign goods and commodities and, with the exception of subsistence farmers, nearly everyone in China is a net importer.

The tea seller is an importer if his tea is delivered to him in fuel-hungry trucks. So is the family planning to visit Egypt next year. The local provider of French perfumes is also a net importer, like the teenager who wants to buy Nike shoes, and so pay for the corporate sponsorship of a Brazilian soccer star playing for a Spanish team.

Every household and nearly every mainland business is, in one way or another, a net importer. So, one way to think about the impact of a yuan revaluation is that it represents a large shift of wealth from the central bank, exporters, and commodity stockpilers to households. This is why revaluation is part of the rebalancing process. By shifting wealth to ordinary households, it increases their consumption relative to gross domestic product.

Of course, we need to distinguish between the balance sheet impacts and the long-term economic impacts of a revaluation.

A revaluation of the yuan certainly will help the economy rebalance in the long term towards a healthier and higher value-added growth path, but it will cause unemployment to rise in the short term. There is a legitimate debate about whether or not the long-term benefits justify the short-term cost, but it is important to recognise the difference between the balance sheet impact and these economic costs and benefits.

Fears that a revaluation will force a balance sheet loss on China fail completely to understand how balance sheets operate.

Michael Pettis is the senior associate of the Carnegie Endowment for International Peace and finance professor at the Guanghua School of Management at Peking University