At the heart of Sino-American trade tensions is the claim that China’s surging exports are a result of Chinese subsidies. But the driving force behind this glut of cheap goods is a significantly undervalued renminbi, a result of high capital outflows caused by both domestic policies and US restrictions on investment in China.

Allegations about China's manufacturing overcapacity have sparked heated discussions among policymakers. During her visit to China in April, US Treasury Secretary Janet L. Yellen argued that "when the global market is flooded by artificially cheap Chinese products, the viability of American and other foreign firms is put into question," adding that it was the same story a decade ago.

Yellen is partly correct: the Sino-American trade war has strengthened, not weakened, China's export competitiveness. In 2023, China accounted for about 14% of total global exports, up 1.3 percentage points from 2017 (before the conflict began). More striking still, China's trade surplus was around $823 billion in 2023, nearly double what it was in 2017.

Over a decade ago, China's trade surplus was largely the result of an undervalued renminbi (RMB). Today's circumstances are somewhat similar. My research shows that in 2023, the RMB was 16% undervalued against the dollar, contributing to China's high exports and trade surplus.

I reached this conclusion because the inflation rate in the United States over the past two years has been ten percentage points higher than in China. According to purchasing-power-parity calculations, the RMB should have appreciated by 10% against the dollar; instead, it depreciated by 11%. From this perspective, the RMB was 21% undervalued against the dollar.

Of course, short-term exchange rates are influenced more by the interest-rate differential than by the inflation rate. I therefore used econometric methods, incorporating factors such as the interest-rate spread and economic growth, to estimate what the RMB exchange rate should be.

My comparative studies found that the extent of RMB undervaluation has been much greater than that of major ASEAN currencies over the past two years. Compared to the last round of US Federal Reserve rate hikes during 2015 to 2018, the extent of the RMB's undervaluation in recent years has also significantly increased.

Strangely, there is no evidence that the Chinese government is targeting the exchange rate. Even the US agrees that China has not acted as a currency manipulator in recent years. In this respect, the situation today is very different from a decade ago, as China has made significant progress in reforming its exchange-rate system in the intervening period. As a result, the volatility of the RMB exchange rate has become more pronounced.

This raises the question of why the RMB is still undervalued. Looking at the balance of payments in 2020 and 2021, the cumulative net inflow of capital from direct and securities investments exceeded $400 billion, whereas in 2022 and 2023, the cumulative net outflow from the capital and financial account exceeded $500 billion. China's enormous current-account surplus has not led to RMB appreciation - as one might expect - because of these high capital outflows. This makes exchange-rate changes ineffective in adjusting the trade balance.

Such capital outflows cannot be attributed solely to the changes in the interest-rate spread between China and the US. In fact, the capital outflow is mainly a result of non-economic factors, including some of China's own policies such as its clampdown on certain industries. Recognizing this, the Chinese government began to incorporate non-economic policies into its self-assessment framework late last year.

More importantly, the recent escalation of Sino-American tensions has led the US to adopt a series of policies that discourage investment in China. This includes limiting venture-capital flows into China and exaggerating the risks of traveling there. The US Congress is also considering legislation that would further restrict American investment in China. Together, these factors have exacerbated capital outflows, thereby amplifying the degree of RMB undervaluation and further undermining the effect that exchange-rate adjustments would typically have on the trade balance.

As long as Sino-American relations continue to be rocky, the RMB exchange rate will most likely remain significantly undervalued, and Yellen's complaints will become ever more difficult to resolve. Of course, the political factors distorting the exchange rate will also slow the development of China's services sector, and thus hinder its structural-adjustment efforts.

Given all this, the solution seems clear. In the interest of both sides, China must develop a consistent mechanism for assessing the impact of its non-economic measures, and the US must ease its restrictive policies.

From Project Syndicate

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