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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.