China’s Currency Dilemma

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– A 2006 BBC headline “Bush presses China over currency” speaks volumes about the intractability of American efforts to get China to raise the value of its currency, the renminbi (or yuan) against the US dollar.  The US public sees China’s undervalued currency as a major factor in the huge US-China trade deficit and the loss of jobs.  Economists and the retail sector dismiss this, arguing if it weren’t China then another country would be making the low value-added products so popular with American consumers. They also attribute the problem to more fundamental factors such as persistent budget deficits and credit driven over-consumption.

Regardless, the US trade deficit with China is a high-order political hot button.  A good argument has been made that China has played the role of enabler of American budget deficits, recycling its trade dollar surpluses by buying billions of dollars worth of US Treasury Bonds, corporate paper and other assets.  China made a largely politically driven choice to subsidize American budget deficits and consumer spending, rather than letting the yuan appreciate naturally.  Chinese leaders have followed this policy in order to keep the export machine humming and maintain 8-11 percent annual GDP growth.  Without these high rates of growth, Chinese leaders worry that the Communist Party cannot maintain legitimacy and its monopoly of power.

In response to their own political imperatives to preserve domestic jobs, Congress has repeatedly introduced and sometimes passed legislation seeking to force the President and the Treasury Department to declare China as a currency manipulator.  In fact, the debate over whether China is an “unfair” trader goes as far back as the late 1990s over granting Permanent Normal Trade Relations (PNTR) to China and US support for its accession to the WTO. 

“China’s Choice”

Thus far, despite Congressional, industry and labor pressure, no US administration has declared China a currency manipulator.  Reflecting the limits of US influence, Treasury Secretary Timothy Geithner declared in early April 2010 that while he was confident that Chinese policymakers understood that it was in China’s interest to allow the yuan to appreciate, the decision to do so was “China’s choice.”

Why have successive American administrations refused to declare China a currency manipulator?  First, China’s fast economic rise and rapid military modernization has created a tangled web of intersecting bilateral interests or “equities” that could be jeopardized by antagonizing Beijing.  These include crises in North Korea and Iran, maintaining peace in the Taiwan Strait and climate change, to name but a few.   The Treasury Department delayed a required report to Congress so as not to jeopardize Chinese President Hu Jintao’s participation in the April international nuclear security conference in Washington and the semi-annual US-China Strategic and Economic Dialogue held in Beijing in May.

Second, the U.S. addiction to China’s US Treasury Bonds purchases continues.  Because of current global financial instability and the sharp drop of the Euro, the dollar remains the safest reserve currency. The combination of a global flight to the dollar and China’s own “dollar-trap” – selling dollars will force down the value of its remaining bond holdings – has made it possible for the Obama administration to stimulate the US economy with huge budget deficits while keeping interest rates low.

Third, economists and US economic policy makers tend to believe that even if China does appreciate its currency, it might not make that much difference.  In 2005 China revalued the yuan upward by 20 percent against the dollar, but the US trade deficit continued to grow and reached a peak of $260 billion in 2008.  Economic analysis is necessarily based on “all other things being equal.”  In real life they are not.  Moreover, a stronger yuan could have some unwanted consequences such as making US property and corporate assets comparatively cheaper for would-be Chinese buyers.

But a Difficult Choice

Until the turmoil in financial markets caused by the prospect that Greece, Portugal, and even Spain might have to default on their international loans, there were good reasons to think that China would soon make some currency policy changes.  China may still take some positive action around the semi-annual G-20 summit meeting in Toronto, not to please the U.S., but to promote and higher value-added based growth.  China bested its leader’s minimum target of 8 percent growth in 2009, but mainly because of a near-trillion U.S. dollar budget deficit and loose monetary policy that now threatens a real estate bust in some of its most prosperous coastal cities.

But China’s political leaders and economic managers face very difficult policy choices. While longer term currency appreciation looks increasingly attractive, the short term costs and benefits have become less clear-cut. China needs to raise its currency valuation to take the economy to a higher level of value-added production, which involves the importation of expensive equipment and technology.  A higher valued yuan also would give China more buying power to pay for its seemingly insatiable demand for imports of raw materials and energy and to support its mercantilist strategy of locking up these resources by investing in their exploitation around the world.

Adding to this dilemma, all of the key numbers on exports, imports, foreign investment, inflation, money supply, labor costs and other economic factors are changing erratically from month to month.  China itself will be strained to support high deficit spending after another year without an inflationary spiral.  In his March 2010 “state of the nation” address, Premier Wen Jiabao warned that the country was by no means on the way to economic recovery and that it was still facing a “very complex situation.”  He said that 2010 would be the crucial year to curb rising inflation and generate solid growth in productive domestic investment and consumption. 

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