Saturday, 16 October 2010

Joseph Stiglitz and China’s exchange rate

By John Ross

Nobel prize winner Joseph Stiglitz hit the nail right on the head regarding the economically invalid character of most arguments presented in favour of RMB revaluation in a video on the Wall Street Journal site on 9 October. He said: “Changes in the exchange rate can actually increase imbalances. The reason is that if the demand elasticities for Chinese goods are relatively low, then when the exchange rate increases the quantity goes down less than the price goes up. And US spending actually goes up. So the net increase could be an increase in the trade imbalances. So the notion that this is a panacea is clearly wrong.”

Exactly and put beautifully succinctly. To explain the point at rather greater length, less gracefully and in more detail, we would cite this blog on 15 June: “The RMB’s exchange rate is clearly an issue deserving the most precise economic analysis given that it involves the world’s largest exporter, China, and the world’s largest economy, the US. It might therefore seem surprising that a frequent feature of calls for early RMB revaluation are attempts to justify this through what are in a quite literal sense economic 'non sequiturs' - non-sequitur being Latin for ‘it does not follow’.

“Such arguments consist of two sentences. ‘China runs a trade surplus. Therefore to eliminate it China should increase the exchange rate of the RMB.’

“Unfortunately elementary economic reflection will show that the second sentence does not necessarily follow from the first. Consideration of supply and demand reminds us that an increase in the exchange rate of the RMB will only reduce China’s export earnings if demand for China’s exports is elastic – that is any percentage fall in sales is greater than any percentage rise in price resulting from revaluation. Equally China’s imports in value terms will only rise if any increase in their volume is greater than any fall in their price due to revaluation.

“The question of whether China's trade surplus will fall or rise in response to RMB revaluation is therefore a matter of fact, not of logic, which therefore has to be examined empirically - as the paper below notes. It quite simply does not follow that an increase in China’s exchange rate will logically necessarily lead to a fall in China’s trade surplus. Indeed it is quite possible logically, for example if demand for China’s exports is inelastic, and the volume of its imports is not particularly price sensitive, that a rise in the RMB’s exchange rate will lead to an increase in China’s trade surplus.

“Given the seriousness of the issue one would have thought that if this matter were being dealt with objectively the US administration would have produced a mountain of material to justify its claim that an increase in the RMB’s exchange rate would lead to a fall in China’s trade surplus - China has certainly produced abundant data, including directly by the Commerce Minister, showing the opposite. But no such material has been forthcoming from the US administration. Instead there is the intoning of a literal non-sequitur.

“The reason evidence has not been produced by either the US administration or by those in agreement with it is that at least as regards the immediate and medium term economic situation their argument is factually false. As is shown in the paper below an increase in the RMB’s exchange rate would immediately lead to an increase in China’s trade surplus and not to a fall – and this is one of the last things which the world requires while attempting to emerge from the international financial crisis.“

For those who read Chinese the article is available in the May edition of International Finance and for details of the factual material readers are referred to the original post. However to show the crucial point, one chart from the original article is reproduced here. This clearly shows that from 2005-2008 as the RMB’s exchange rate went up China’s balance of payments increased - driven by the trade surplus. This is exactly what would happen under conditions of inelasticity of demand for China’s exports and imports and the exact opposite of what would occur if demand for China’s exports and imports were elastic. In short, as the claim that China’s trade surplus would go down in response to an increase in the RMB’s exchange rate depends on demand for China’s exports and imports being elastic the evidence is that this is simply not true - for why they are not elastic readers are referred to the original article.

Figure 1

10 03 19 BofP & ERate

A student of economics learns in roughly week two of that course that what happens in response to an increase in price (in this case an increase due to a rise in the RMB’s exchange rate) depends on whether demand is elastic or inelastic. If demand is inelastic then the amount spent on the good goes up and not down.

That those calling for RMB revaluation are forced to 'ignore' such an elementary point in economics, which they assert with no proof and with the evidence being against, shows their arguments are not coherent. To demonstrate that China’s trade surplus would decrease with RMB revaluation they have to prove that demand for China’s exports and imports is elastic. The don’t do so because the evidence is the opposite. That is why claims are made that someone studying economics for two weeks would know have to be factually justified and are not being – that is, there is a logical hole right in the middle of the argument.

As an economist of Stigltz’s standing has now made the point one might hope that those promoting RMB revaluation as a way to reduce China’s trade surplus would feel forced to attempt to factually justify their arguments instead of merely repeating their economic non-sequitur. Unfortunately, as a large number appear more interested in prejudice than either serious economic argument or dealing with the very serious and real issue of global economic imbalances this is not necessarily going to happen.

Keynes famously wrote: ‘I am sure that the power of vested interest is vastly exaggerated compared with the gradual encroachment of ideas.’ (Keynes, 1936, p. 383) But by ‘gradual’ Keynes precisely acknowledged that this was a long-term process. Nevertheless the fact that an economist of Stiglitz’s standing has made the central point clearly and bluntly may, in a ‘gradual’ way, help put a stop to a campaign based on an economic non-sequitur and instead get down to a serious discussion on a very serious topic – i.e. how to correct current global imbalances.


A reader has pointed out that the graph reproduced from the original post showed China's balance of payments surplus plotted against its exchange rate - this was used in the original article as it was analysing the full international effect of China's surplus. They asked what about China's trade surplus plotted against the RMB exchange rate, to isolate the specific effect of the exchange rate on trade?

This is shown in the graph below. As may be seen the trend is exactly the same - China's trade surplus went up as its exchange rate went up.The only difference is that at the beginning of the period China had a -0.1% of GDP deficit on income from abroad and by the end of the period it had a 0.7% of GDP surplus, but there is no difference in trend.

10 10 11 Balance of Trade and E Rate

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This article originally appeared on the blog Key Trends in Globalisation.


Deming, C. (2010, March 31). The Surplus of Promise. Retrieved October 11, 2010, from China Daily:

Keynes, J. M. (1936). The General Theory of Employment, Interest and Money (Macmillan 1983 ed.). London: Macmillan.

Ross, J. (2010, June 15). The Real Consequences for the International Economy of an Early Increase in the RMB's Exchange Rate. Retrieved October 11, 2010, from Key Trends in Globalisation:

Stiglitz, J. (2010, October 9). Economist Joseph Stiglitz's Take on China. Retrieved October 10, 2010, from Wall Street Journal:

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