| Japanese Lessons for China’s Currency SHANGHAI – The question of how much China’s currency should appreciate to rebalance its trade has become a global hot-button issue . But the answers have been all over the map , with some finding that the yuan is not undervalued at all , while others argue that it should appreciate against the dollar by more than 30 % . Clearly , there must be major differences in the macroeconomic models used to produce such a wide range of estimates . But the one thing about which everyone seems to agree is the theoretically and empirically unjustified assumption that an equilibrium exchange rate actually exists . The theoretical problem is simple : a country’s trade balance depends on a lot more than the value of its currency in the foreign exchange markets . Interest rates , employment , aggregate demand , and technological and institutional innovation all play a role . As the economist Joan Robinson pointed out in 1947 , just about any exchange rate will be the equilibrium value for some combination of these other variables . The equilibrium exchange rate , she famously argued , is a chimera . Not surprisingly , the empirical evidence that trade imbalances can be resolved through exchange rate changes alone is unconvincing . In the case of China , the most useful precedent is probably that of Japan in the period from the end of the Bretton Woods fixed exchange-rate regime in August , 1971 , to the collapse of its “ bubble economy ” in 1990. During that period , the yen’s value more than doubled against the dollar , rising from its original fixed rate of 360 to 144 at the end of 1989. Yet , even as Japan’s exports became much more expensive in dollar terms and its imports much cheaper in yen , its trade surplus rose from $6 billion in 1971 to $80 billion in 1989. For two decades , expectations that an appreciating yen would restore external balance were repeatedly disappointed . At the time of the December 1971 Smithsonian Agreement , 308 yen to the dollar was supposed to do the trick . Fourteen years later , during the Plaza Accord negotiations , the Japanese argued for an eventual level of 200-210 , while some US Treasury officials thought the final target should be as high as 165-170 . At the end of the 1980’s , some analysts thought rates as high as 120 might finally produce the long-sought equilibrium . Yet , as Japan entered the “ lost decade ” of the 1990’s , its exports continued to grow faster than its imports . Japan’s trade surplus peaked only in 1994 , at $144 billion , just a few months before the yen’s April 1995 all-time high of 79.75 . In retrospect , it is easy to see why none of these supposed equilibrium exchange rates delivered external balance . As the yen appreciated , Japan responded not by exporting less but by improving productivity and quality control through plant and equipment investment and innovations in factory management , making possible rapid growth in exports of high-value-added products . Exchange-rate equilibrium calculations from the 1970’s and 1980’s , which could only have been based on the export sector’s contemporary structure , naturally would have little relevance subsequently . The same is true of calculations at the beginning of the 1990’s , which would have forecast Japanese import growth based on extrapolations from the high GDP growth rates of the previous 40 years rather than on the decade of stagnation that ensued . In China , changes in the export sector’s structure similar to those observed in Japan are now taking place . These changes are likely to make today’s attempts to find an equilibrium yuan-dollar exchange rate seem just as chimerical in hindsight as previous calculations of the yen-dollar equilibrium rate . For the 30 years since the beginning of China’s economic reforms , Chinese industry has achieved impressive efficiency gains by adopting new technologies and realizing economies of scale , leading to a huge expansion in locally made products suitable for export . While an appreciating currency might eventually drive labor-intensive manufacturers out of business , if Japan’s economic history is any guide , they are likely to be replaced by producers of things like ships , machine tools , semiconductors , and doubtless new products yet to be invented . The equilibrium yuan-dollar rate is a chimera not because China’s trade could never be balanced , but because the exchange rate alone does not determine equilibrium . The structure of the entire economy matters , too . As this is constantly evolving in unpredictable ways , there is no reason to expect that the assumptions underlying any particular macroeconomic model will ever remain valid long enough for its steady-state solution to be achieved in practice . |