Is the Yuan Exchange Rate a Subsidy?

The other day Nouriel Roubini pointed out how dangerous he thought Ben Bernanke's flirtation with the word "subsidy" in a speech in China last week was. As Mark Thoma (see also Menzie Chinn, among others) noted last week, the text of Bernanke's speech in Beijing called the yuan peg (which is more accurately a crawling peg) against the dollar an "effective subsidy". However, Bernanke spontaneously reworded that description to "distortion". Originally, his speech read like this:

Greater scope for market forces to determine the value of the RMB would also reduce an important distortion in the Chinese economy, namely, the effective subsidy that an undervalued currency provides for Chinese firms that focus on exporting rather than producing for the domestic market.

The problem with that language, as Nouriel points out, is that the word "subsidy" has a specific legal meaning which allows for specific legal retaliations, such as import tariffs. In fact, all members of the WTO have agreed to the following precise definition of what an export subsidy is:

For the purpose of this Agreement, a subsidy shall be deemed to exist if there is a financial contribution by a government or any public body within the territory of a Member (referred to in this Agreement as “government”), i.e. where:

(1)

• a government practice involves a direct transfer of funds (e.g. grants, loans, and equity infusion), potential direct transfers of funds or liabilities (e.g. loan guarantees);
  
• government revenue that is otherwise due is foregone or not collected (e.g. fiscal incentives such as tax credits);
  
• a government provides goods or services other than general infrastructure, or purchases goods;
  
• a government makes payments to a funding mechanism, or entrusts or directs a private body to carry out one or more of the type of functions illustrated in (i) to (iii) above which would normally be vested in the government and the practice, in no real sense, differs from practices normally followed by governments;

or

(2) there is any form of income or price support [which operates directly or indirectly to increase exports of any product from, or to reduce imports of any product into, its territory].

Clearly, China's exchange rate regime does not qualify under the first set of criteria. The only way one could consider it a subsidy is if one argued that it constituted a form of price support, under the second criterion. But it's hard for me to see how a fixed exchange rate could be interpreted as a "price support", since the exchange rate says absolutely nothing about what price producers will receive for the goods they sell. All it does is guarantee the price everyone will receive if they sell one currency in exchange for another.

Moreover, the very first line of the definition of a subsidy states that there must be a financial contribution by the government to the firms that benefit. China's fixed exchange rate does not involve any such financial contribution. Maintaining the peg merely involves a change in the composition of the PBoC's balance sheet - it holds more yuan liabilities and more dollar assets. So I can't see how a fixed exchange rate regime could conceivably be equated with the definition of a subsidy that the US (and every other WTO signatory) has already agreed to.

But suppose that you wanted to rewrite the definition of "subsidy". That causes its own set of problems. In particular, I think it would be impossible to find any broadly-accepted criteria to define when a fixed exchange rate is a subsidy.

Lots and lots of countries have had fixed exchange rates, including scores of countries today, and nearly every country (including the US) at some point in the past. Were they all providing a subsidy to their exporters? Clearly not. So how do you tell when a fixed exchange rate is a "subsidy"?

Does it depend on whether a country has a current account surplus? Should we stipulate that any time a country has a current account surplus, together with a fixed exchange rate, it is subsidizing its exports? Well, in that case we would have to include lots of other countries around the world that have current account surpluses and fixed exchange rates. Thailand and Malaysia, for example, and Venezuela, and most of the Persian Gulf countries, all have fixed exchange rates and current account surpluses much bigger than China's. Germany, Belgium, and the Netherlands all have a fixed exchange rate (known as the euro) with most of their major trading partners, and substantial current account surpluses. Even the US had a fixed exchange rate along with regular current account surpluses through most of the 1950s and 60s. In fact, one could come up with literally hundreds of examples over the past 50 years where a country has met those conditions. Were all of those instances examples of "effective subsidies"?

Maybe some different criteria would work better. Maybe a country is only providing an "effective subsidy" to its exporters if it has a fixed exchange rate and is accumulating foreign reserves to maintain the peg. But by that criteria, nearly every country in the world with a fixed exchange rate qualifies, since nearly every country in the world has been gaining foreign currency (mainly dollar) reserves in recent years. Many African countries have been gaining foreign reserves at an even faster clip than China has, in fact (though they're much, much smaller, so in absolute terms their gains are tiny by comparison to China's reserve increases).

In other words, I don't think that there are any reasonable, objective criteria that could be agreed on to decide whether a country's fixed exchange rate qualifies as an "effective subsidy" to its exporters. And as Nouriel wrote, without a generally accepted definition of when exchange rate management should be considered a subsidy, there would be literally scores, if not hundreds, of possible accusations of countries "subsidizing" their exporters, and no way to adjudicate between the frivolous cases and the ones with merit.

In short, I'm glad that Bernanke pulled back from using the word "subsidy" in his remarks. But I'm dismayed that he came as close as he did to opening that Pandora's Box.