Audrey Deschenes
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Is China in danger of falling into the trap that killed Japan?

Pressure to overvalue yuan could stifle China, just as an overvalued yen killed Japan

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A Chinese vendor waits for customers at her stall selling wholesale remote controls at the Yiwu International Trade City. A slowdown in Chinese exports has triggered global concern of a drop in economic growth.

China is now experiencing what Japan went through a generation ago: a marked slowdown in economic growth after demands by the United States that it restrict its exports.

In the late 1980s and early 1990s, Japan was criticized by the U.S. as an “unfair trader” by virtue of its soaring manufacturing exports. The U.S. issued stern, and apparently credible, threats to restrict Japanese imports, and succeeded in pushing Japan to overvalue the yen USDJPY, +0.03% , which helped to bring Japanese growth to a screeching halt.

That may be happening again, with China’s growth slowing markedly under the weight of an overvalued currency urged by the U.S.

Figure 1 shows the yen’s real (inflation-adjusted) exchange rate from 1964 (when the yen became convertible on the current account) until today. A rise in the index signifies real appreciation, meaning that the yen became more expensive relative to other currencies after correcting for relative price-level changes.

As one can see, the yen appreciated gradually in the 1960s and 1970s, as one would expect, given Japan’s rapid catch-up growth of those decades. Then came the trade pressures from the U.S., and Japan agreed to a major realignment of currencies in the mid-1980s, starting with the so-called Plaza Accord in 1985.

The yen appreciated substantially as part of that multi-country intervention, with the real appreciation reaching roughly 50% from 1984 to 1988. And, as Figure 2 shows, Japan’s export growth plummeted.

For a brief period, a domestic investment boom offset the export slowdown. With the yen seeming to have no place to go but up, foreign money flooded into Japan. A financial bubble developed. By 1990, the investment boom had become a bust, the asset bubble had burst, and Japan began two decades of stagnation.

Despite the Japanese economy’s chronic underperformance, the U.S. continued to press Japan to maintain an overvalued yen throughout this period. During the 1990s and 2000s, I repeatedly asked senior Japanese Finance Ministry officials why they allowed the yen’s real appreciation to persist, thereby shutting down export growth. The answer was always the same: Japan was afraid of U.S. trade retaliation if the yen weakened.

It is only with the Bank of Japan’s quantitative easing since the launch of “Abenomics” in 2012 that the yen’s real appreciation has been reversed somewhat. Predictably, some U.S. industrial lobbies are again complaining that Japan is manipulating its currency, even though the yen’s real depreciation since 2012 has merely reversed the preceding growth-killing real appreciation.

China now confronts the risk of the same sequence of events. Its booming exports in the mid-2000s led U.S. officials to threaten trade retaliation unless the Chinese authorities took steps to restrict exports, cause the renminbi (also known as the yuan) USDCNY, -0.1635% to appreciate, and shift to “consumption-led growth.”

This is the same message once given to Japan. The U.S. insistence on renminbi appreciation intensified after the onset of the 2008 financial crisis.