Should China Revalue its Currency? Lessons from the Japanese Experience

There is a similarity of pattern between the present international pressures for RMB revaluation and pressures which were exerted on Japan in the ‘80s for Yen revaluation. The undervaluation of the RMB has been much debated over the past four years and again China has been recently under strong international pressure to revalue its currency.

This paper aims at clarifying certain issues raised by this debate on the RMB revaluation in the light of Japan’s experience after the 1985 Plaza Agreement, which led to a quasi-doubling of the Yen exchange rate against the US$ over a period of two years.

As to the first question whether the RMB is undervalued, such an undervaluation has to be assessed on the basis of the real effective exchange rate (REER) and not only of the market forex rate against a falling US$. On a REER basis, the undervaluation of the RMB may be estimated in the range of 15-20%, which would mean about 10-15% against the US$ and 20-25% against the Euro.

The next question is whether China should let its currency appreciate gradually or proceed immediately to a massive RMB revaluation of 20-25%, as requested by the US and Europe? A steep revaluation of the RMB would have probably devastating effects on China’s economic growth and stability, while it would not solve the problem of the growing trade deficits of the US and Europe. This is confirmed by the example of Japan during the ’80s and ’90s: the quasi-doubling of the Yen exchange rate against the US$ after the Plaza Agreement did not reduce the US trade deficit, but its negative effects have weighted on the Japanese economy and financial system throughout the ’90s.

As for the US and Europe, the key for the reduction of their trade deficits is not primarily in the RMB revaluation but in a continuing improvement of their technological competitiveness, as shown by Japan, whose booming trade with China over the past years has remained quite balanced.

Finally, the appraisal of China’s foreign exchange policy over the past years gives rather mixed results. For the period 2005-2006, the policy of a very gradual RMB appreciation of its currency seemed justified. However the appreciation of the RMB effective exchange rate has been far too slow in 2007. This over prudent policy does not seem any more in the best interest of the Chinese economy itself, without speaking of the relations with trading partners. The explosion of the current account over the past years would now require that China make full use of the instruments given by the reforms of July 2005 for the optimal management of its currency.