The Chinese Union

Could China and Hong Kong create a common currency?

Over the weekend, millions of Chinese exchanged red envelopes filled with cash to celebrate the advent of the Year of the Snake. Oddly, most of those envelopes contained a currency that lumbers in the shadows of international markets, the yuan. The world's biggest exporter and second-largest economy still lacks a currency that can be used freely around the globe. China wants this to change, but how and when?

These are questions of intense interest to investors, speculators, and corporate managers around the globe. Right now, the yuan's value moves within a band enforced by the People's Bank of China, and there are restrictions on how it can be used by foreigners. A convertible yuan would trade without limits on currency markets, becoming more liquid, permitting bigger transactions, and responding more quickly to changes in the demand for Chinese assets and products. Convertibility would also pave the way for the yuan's use as a reserve currency by central banks and sovereign wealth funds, and perhaps even as the standard currency for pricing some commodities, such as copper. 

These things would benefit China. When other countries use your currency for their reserves, they link their economic fortunes to yours. The stability of your currency is of material interest to them, and they can even help to defend your currency against speculative attacks or other unwanted fluctuations. And when your currency is used in trade, the private sector needs to hold more of it, lowering the cost of financing.

Naturally, China's present regime for the yuan also has some benefits. People who do business with China can count on a fairly narrow range for exchange rates, so it's easier to make long-term contracts. Convertibility would erase this implicit guarantee, but it would simultaneously solve the problem of volatility by opening the door to much greater hedging. Multinational companies could trade yuan and related derivatives by the billion to balance their risks. So far, China has taken only baby steps in this direction, with the first yuan futures hitting the markets just last September.

Typically, a country in China's situation might move to convertibility once it felt comfortable opening its financial markets and relying on domestic demand to drive the economy. But China has a complication: Hong Kong. The city-state became part of the People's Republic in 1997, but it maintains its own economic system and its own currency, the Hong Kong dollar (HKD). With a population of just 7 million, its exports amount to a quarter of the total for the rest of China.

Just as convertibility is a long-term goal, so is reincorporation of Hong Kong into the Chinese economy. Today this process would be like a snake swallowing an ostrich egg. Yet China is changing rapidly, both in terms of financial sophistication and the openness of its markets. With time, Hong Kong will be less different from the rest of China, and thus the separation will seem less necessary. If the yuan is to become convertible, it will likely be as part of a long-term plan for economic convergence.

Paradoxically, however, as China has grown more similar to Hong Kong, its currency's value has diverged. For the past three decades, the HKD has been pegged to the U.S. dollar within a very slim band, roughly 1 percent of its value. Meanwhile, from 1995 to 2005, the yuan had its own peg to the American dollar and was reliably worth about HKD 0.93. But since 2005, the yuan has risen to HKD 1.23 as China's trade deficit has dwindled. 

Recently, there has been pressure on the HKD to appreciate as well, thanks to enormous incoming investment in real estate and other assets -- driven, of course, by China's growth. Hong Kong's monetary authorities will not give up their peg lightly, however. Their bosses have long advertised the HKD's rare combination of convertibility and a virtually fixed exchange rate as a godsend for companies involved in global commerce.

But the presence of a convertible yuan might force them to reconsider their currency regime. Two-way trade between Hong Kong and the rest of China is worth close to $200 billion each year and will surely continue to grow. With a convertible yuan, the exchange rate for all that trade would become completely unpredictable. 

Unfortunately, the obvious solution to this problem -- a currency union -- is not a particularly good one at the moment. To be sure, a single Chinese currency would not keep Hong Kong from holding on to many other distinct aspects of its economy. Its legal, tax, and regulatory systems could still remain independent. Rather, the problem is that Hong Kong and China have not met enough conditions for a successful currency union; though their trade is fairly free, they don't share fiscal policy or allow unfettered migration, and hence their economic cycles have yet to synchronize. With monetary policy set in Beijing, as it surely would be, Hong Kong's economy would probably be in for a bumpy ride.

More likely, Beijing will use convertibility as part of a gradual program to dismantle Hong Kong's monetary independence. Once the yuan becomes convertible, China will undoubtedly encourage its use in Hong Kong. Just as the euro is used in some European Union countries that have yet to adopt it, and the dollar is used around the world, the yuan will operate alongside the HKD until conditions are right for a changeover. 

Pressure will grow on the Hong Kong authorities to allow the HKD to rise in anticipation of an eventual currency union. Hong Kong's "high degree of autonomy" is guaranteed until 2047, but smoothing the eventual transition into China is a high priority that officials on both sides are already discussing. Though a shared fiscal policy is unlikely, free migration will become less of a political liability as China gets wealthier. In this light, and given the heroic efforts needed to protect the peg to the American dollar, Hong Kong's leaders may eventually become willing partners in a currency union.

Xi Jinping, China's new leader, has strong ties to the country's entrepreneurial south and is expected to usher in the next major wave of economic reforms. He will likely have two five-year terms to bring the rest of China closer to Hong Kong, perhaps assisted by Yi Gang, a talented governor-in-waiting at the central bank. Convertibility would make a good capstone for term number one. Currency union may have to wait for his successor.


Daniel Altman

Free Trade: You're Doing It Wrong

Want to make progress on trade? Pay off the losers.

The World Trade Organization made news last month because of the record number of candidates seeking to be its new director-general. Alas, they're probably in it more for the salary and prestige than for any résumé-building accomplishments. After all, the WTO has done little to open global markets since the Doha round of trade talks began in 2001. The reason is simple: Its members are doing free trade all wrong.

That's too bad, because basic economics teaches that two people who trade with each other always end up better off. Why else would they trade in the first place? Putting aside issues of coercion and uncertainty, the idea is that there are gains from trade to both sides whenever a transaction occurs. Realizing those gains by buying and selling goods, services, assets, and labor is one of the keys to economic growth.

The same is true for countries, but there's a wrinkle: Though two countries that trade with each other will also achieve gains from trade, their people won't necessarily share those gains equally. Indeed, both countries will be better off overall, but inside each country there will be winners and losers. This is why people ranging from Korean farmers to American autoworkers turn out in numbers to protest free trade agreements.

But free trade needn't be such a divisive issue. At the national level, the benefits from free trade always outweigh the losses; this has to be true, since each new transaction creates its own gains from trade. Put another way, a country that opens its markets is always richer as whole. And so here's the genius part: It should be possible for the winners to compensate the losers so that everyone is better off, or at least no worse off than they were before.

This redistribution of the gains from trade is not an afterthought. It is an essential part of the process of opening markets. Done right, it practically guarantees that everyone in a country can and will support free trade. Yet no one in the world does it well, or even tries to.

Sure, there are programs such as Trade Adjustment Assistance (TAA) in the United States and the Globalization Adjustment Fund in the European Union. But they're tiny and relatively ineffective. TAA for workers amounts to about $1 billion a year -- about 0.007 percent of U.S. GDP -- and the program's record of helping workers to find jobs that fit their skills is middling at best. The EU's fund granted only 128 million euros in 2011, the last year for which complete figures are available, helping just 0.009 percent of the union's roughly 240 million workers. More recent payments have been tied up in ongoing budget talks, and several countries have called for the fund to be abolished altogether. Clearly, there is little political appetite in the world's two biggest economies for a more serious attempt at redistributing the gains from trade.

Not that it's easy. To start, you have to know how much is gained and lost by whom. Consider the big winners from trade. They include shareholders and employees of export companies that find new customers abroad, importers that can offer new products at home, and other businesses that can get cheaper inputs. Then there are all the consumers who can buy new or cheaper goods and services. What is the value of trade to these people? Next, consider the big losers: workers whose jobs disappear and shareholders whose companies fold because of foreign competition. How much economic damage has been done to them?

Economists can -- and routinely do -- answer these questions with statistical estimates. The tougher question is how to accomplish the redistribution. You can't tax new imports to skim off some of the benefits to consumers, since the whole point of a free trade agreement is to render imports tariff-free. You could, however, make people pay for the agreement itself.

But how? One idea would be to identify the prospective winners of a new trade agreement and ask them to contribute lump sums to a fund that would compensate the losers. The trade agreement would go forward much as buyouts do in the stock market; if enough of the winners signed up and contributed, the rest of them would be compelled to pay, perhaps on their annual tax bills. Then the fund -- likely to hold a lot more than $1 billion for any major agreement -- would be divvied up between the losers.

In addition to solving the redistribution problem, the fund would help everyone, winners and losers alike, to understand how trade affected their economic futures. Moreover, it would allow the losers to spend their compensation however they saw fit; some might choose to retrain for a higher-skill job, while others might prefer to take a lower-skill job and buy a new car. Of course, some people might try to weasel out of the winners' category and paint themselves as losers. But the government already does a reasonable job of figuring out who should receive various payments and benefits, from emergency relief to unemployment insurance. Fraud in this case would be even harder -- how do you fake a decades-long career in manufacturing?

No, the biggest obstacle for the new mechanism might be getting politicians and the public to trust economists, their statistical models, and a dose of new thinking. Until that happens, the WTO will continue to twiddle its thumbs, and gains from trade will still be left on the table.