beyondbrics

By Eduardo Lora and Alessandro Rebucci of the Inter-American Development Bank

Suffering from excessive capital inflows and exchange rate appreciation, several Latin American leaders have sided with the United States in recent months and supported calls for a revaluation of the Chinese renminbi.

The reasoning is that a stronger renminbi will induce a change in the composition of Chinese growth, away from exports and toward domestic consumption, while giving the rest of the world and Latin America a competitive boost.

An ongoing joint study of the Inter-American Development Bank and the University of Cambridge suggests the opposite.Renminbi revaluation could bring slower Chinese and global growth

A revaluation alone has historically created excess capacity and slowed growth in China. And given China’s present grab in the world economy, a stronger renminbi today would mean weaker economic growth in Latin America and the rest of the world. It could even jeopardize the already weak recovery of the United States and the eurozone.

China’s importance in Latin America has increased dramatically over the past decade. The Asian giant now accounts for about 12 per cent of Latin America’s total exports compared with 2 per cent in the mid-1990s. It has doubled its share of total trade in the United States and the euro area, key trade partners of Latin America. China is also a key player in the oil and other commodity markets in which Latin American exports play a big role.

As a result, Latin America’s business cycle has become much more synchronized with China’s and the relative importance of the United States and the eurozone has diminished.

So far China has been a blessing to Latin America. The limited impact of the global financial crisis on Latin America owes much to the improved economic fundamentals of the region and effective international financial support. But China clearly helps explain why the region has recovered from the crisis so much faster than in past crises. Thanks to China, the region’s economic prospects are bright: commodity and asset prices as well as growth projections for 2010-11 are back up near to pre-crisis levels.

But too much of a good thing may be a bad thing. The region is now trying to manage the boom and, particularly, the capital inflow bonanza. The region’s past experiments with capital controls have been mixed and a revaluation of the renminbi seems like a good solution.

10 per cent renminbi appreciation could cut China’s GDP by 0.5 per cent

Unfortunately, this may not be the case. According to our research, a stronger renminbi could potentially leave millions unemployed in China if not accompanied by policies to support domestic demand, and especially household consumption. For instance, we estimate that a 10 per cent revaluation of the renminbi would reduce growth in China by 0.5 percent, by 0.15 percent in the United States, and by 0.3 percent in Latin America.

There is little Latin America can do to influence China’s macroeconomic policies, even though three of the largest countries in the region are now part of the G20. The region must be prepared to deal with the potential negative consequences of a stronger renminbi.

Latam states must tighten budget, leave exchange rates free and boost competitiveness

Amidst today’s booming external economic conditions, this means three things.

First, countries need to strengthen their fiscal positions by reining in any fiscal stimulus designed to support demand during the crisis, and then adjust structural balances to meet medium-term sustainability goals under conservative assumptions of growth and foreign financing conditions.

Second, the region should refrain from trying to control exchange rates. History has shown that countries that try to control their exchange rates to prevent speculation end up with more speculation. By letting exchange rates float freely, countries can create more uncertainty in the market, discouraging speculative inflows.

And lastly, if Latin America is to improve its competitiveness in manufacturing vis-à-vis China, it must invest more in policies that boost productivity as these include structural reforms to reduce labor informality and improve efficiency in infrastructure, particularly transportation.

A China revaluation alone is not a silver bullet to rebalance the world economy and solve Latin America’s economic problems. On the contrary, it can pose serious risks. Countries must be prepared.

Eduardo Lora is chief economist of the Inter-American Development Bank and Alessandro Rebucci is a senior research economist at the IDB.