China’s exorbitant surplus calls for a much stronger yuan

That would help address global concerns about Chinese reliance on exports for growth, writes Brad Setser.

Why domestic demand alone will not cut China’s surplus

China’s industrial policies have squeezed imports out of the Chinese market; real imports of goods are up less than 5% in the past five years, while domestic demand is, if official statistics are to be believed, up just over 20%.

And exports didn’t magically start to grow faster than global trade when China’s property bubble burst. Export outperformance really started in 2023, after the yuan fell significantly in both nominal and inflation-adjusted terms in the second half of 2022.

How undervalued is the yuan?

China’s currency is now around 21% cheaper than it should be, according to the IMF’s workhorse model. But the reality may be worse.

The model is based on China’s reported current-account surplus of around 4% of GDP — a number that has been artificially held down by China’s implausible reported deficit in its investment-income account and by a 1%-of-GDP surge in gold imports. If the real surplus is closer to 6% of GDP, the yuan would be undervalued by more than 30%.

Such a large undervaluation should not be a surprise. The yuan stopped appreciating against the dollar many years ago, and is now back at its 2008 level against the greenback. If the currency of a country converging towards the technological frontier doesn’t appreciate, it will become quite weak. Look at The Economist’s Big Mac index.

Waiting for Xi Jinping to raise social spending is not the answer

Waiting for China’s leader, Xi Jinping, to raise social spending to the level needed to push China’s inflation above that of its trade partners is not the right way to address global concerns about the country’s unbalanced growth model.

Mr Xi opposes a Chinese “welfare state” and has preferred to subsidise industrial investment rather than household spending. He shows no sign of worrying about pushing imports out of China’s market either. One of his policy goals, after all, is to reduce China’s dependence on imported inputs while increasing the world’s reliance on China.

It would be far easier for China’s trading partners to join the market in pushing for China to allow a stronger yuan. There is a much stronger historical precedent for exchange-rate diplomacy than for a global negotiation over the level of basic retirement benefits.

China spent about $600bn to restrain appreciation

Yes, China’s state financial sector did sell a bit of foreign exchange in 2023 and 2024, back when American interest rates were above 5%. However, the pattern of market pressure has changed since 2025, in part because China’s exporters are no longer willing to warehouse all of the dollars they earn from trade abroad.

China’s state-controlled financial system has had to buy about $600bn in the forex market (and sell an equal amount of yuan) to control the pace of appreciation over the past year. The modest appreciation of the yuan in that time has only reversed the depreciation that came with following the dollar down after “Liberation Day”, when President Donald Trump authorised sweeping tariffs on imports: it hasn’t made a dent in the underlying undervaluation.

A stronger yuan would help China, not hold it back

Calling for a stronger yuan is not calling for a policy that tries to hold down China. A stronger currency would increase Chinese consumer purchasing power and lower the cost of rebuilding China’s depleted oil stocks. Mr Xi might even like the look of a rise in China’s dollar GDP.

In an earlier piece for The Economist, Gita Gopinath, Pierre-Olivier Gourinchas and Hélène Rey expressed concern that a fall in domestic prices would undo the impact of the stronger currency. They need not worry: domestic prices tend to be rigid and largely move with domestic conditions; the underlying pace of change in China’s core-inflation index hasn’t moved with the yuan’s external value over the past five years.

It is true that a stronger yuan, without any change in domestic Chinese policies, most likely would result in slower Chinese growth. That would be a good thing; indeed, it is probably a necessary condition for a shift in China’s domestic policies. China has got an incredible six percentage points of growth from net exports since the end of 2018, with half of that coming in the past two years.

Mr Xi unfortunately doesn’t feel the need to change his policies so long as net exports are keeping China’s headline growth up, even though continuing this unbalanced growth model will undoubtedly lead to protectionist pressures that extend well beyond Mr Trump’s presidency, and well beyond America.

Two goals need two instruments

China’s currency, rather obviously, is still managed. Its path is set by China’s central bank through changes in the daily fix, not the open market. That gives China an independent tool that it could use, if it wanted, to achieve external balance.

It would take a fiscal stimulus alongside a stronger currency to bring China closer to both external and internal balance. Two goals, two independent instruments. For China, exchange-rate adjustment is a necessary complement to fiscal support for consumption.

China’s trading partners, though, are understandably focused on the policy change that will do the most to address their concerns about China’s current reliance on exports for growth. That, put simply, is a stronger yuan. Chancellor Friedrich Merz of Germany and President Emmanuel Macron of France are right to be asking for an upfront appreciation of the yuan. Mr Trump and his treasury secretary, Scott Bessent, might want to join them.■

Brad Setser is a senior fellow at the Council on Foreign Relations.

This article was co-written with David Waddill of Columbia SIPA.

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