Is China's Exchange Rate Policy a Form of Trade Protection?
Makin, Anthony J., Business Economics
This paper examines how China's heavily managed exchange rate contributes to its huge trade surplus with its major trading partners, most notably the United Stales. Based on the distinction between economics' aggregate output and expenditure and on the premise that exchange rates are shared variables, it develops a straightforward framework that shows how exchange rate management by China's central bank affects China's fast growing output, expenditure, employment, and trade balance, while simultaneously influencing these aggregates in its slower growing industrialized trading partners. This framework reveals that under conditions of limited private capital mobility an inflexible yuan yields higher short-run output gains for China at trading partners' expense through a form of "exchange rate protection." At the same time exchange rate misalignment limits China's consumption and hence living standards. A misaligned currency is also shown to bias international saving and investment flows and is central to any explanation of global imbalances. Business Economics (2009) 44, 80-86.
Keywords: China, exchange rate, trade protection, trade imbalance, fixed exchange rate
China's exchange rate policy plays a pivotal role in the nation's economic development strategy, which has lifted over 400 million out of poverty over the past three decades and made China the fourth largest economy and third largest trading nation in the world [World Bank 2008]. However, the tightly managed yuan has created considerable friction with China's trading partners, raising serious international concerns about existing current account imbalances, most notably those between East Asia and the United States.
The Bank for International Settlements  believes that these imbalances pose a serious longer term problem for the world economy, and numerous measures have been proposed in recent multilateral consultation on current account imbalances promoted by the International Monetary Fund . U.S. authorities have also been meeting on a bilateral basis with China through the "U.S.-China Economic Dialogue Program" established in 2007 to facilitate dialogue between U.S. cabinet-level officials and their Chinese counterparts on U.S.-China trade issues, including market access, intellectual property rights, and export controls. The need to understand the domestic and international macroeconomic implications of China's exchange rate policy therefore remains critical.
The fundamental importance of the exchange rate in China's development strategy was recently confirmed by Hu Xiaolian, Deputy Governor of the central bank, the People's Bank of China (PBC), who stated that "China's central bank has supported the economic development goal through its pursuit of currency stability which is its monetary objective" [Hu 2007]. though Chinese Premier Wen has also recently conceded that " ... the biggest problem with China's economy is that it is unstable, unbalanced, unco-ordinated and unsustainable" [quoted in Aziz and Dunaway 2007].
Yet, although a literature has developed on the relationship between China's saving, investment, and its current account surplus [Aziz and Cui 2007; Ito and Chinn 2007], there is a paucity of macroeconomic-oriented analysis focusing on the nexus between China's exchange rate management and the important relationship between its aggregate output and expenditure flows in the much-neglected tradition of Alexander .
The main contribution of this paper is the exposition of a straightforward framework that is founded on links between the exchange rate, output-expenditure relations, and external account imbalances. In the context of China's superior growth record relative to major industrialized trading partners, it models key international linkages to elucidate the significance and policy implications of China's managed exchange rate for China's production, spending, and current account balance. …