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U.S., Chinese Interests May Converge on the Yuan

China-bashing has been a contact sport in the United States for some time now, but with the presidential election less than a year away, verbal attacks on the Asian giant are set to increase sharply. A slowing U.S. economy, weighed down by a housing slump and a credit crunch, will make consumers and businesses even surlier — a mood the presidential candidates, especially Democrats, will be eager to exploit.

Over the long run, the United States has much to lose from a trade war with China, while China has much to gain from a more flexible currency. Although some U.S. lawmakers insist China’s exports are unfairly subsidized by its undervalued currency, U.S. consumers benefit enormously from the availability of cheap Chinese goods. As for China, a more flexible currency would allow the government to use interest rates more effectively as a policy tool, providing greater control over an economy that is expanding at breakneck speed.

As fear of China’s economic prowess continues, several China-related bills — mainly focused on strengthening the U.S. government’s hand in addressing China’s undervalued currency — have been introduced in both the House and the Senate. Despite the threats, U.S. politicians know their ability to influence China’s currency policies is limited. If passed, such legislation may, at best, prod China to let its currency rise in value. More likely, it could elicit exactly the opposite reaction, bringing the prospect of a trade war that much closer. Ultimately, the decision rests with Beijing.

Is the Renminbi Undervalued?

Signs that China’s currency is heavily undervalued are striking. In 2006, China’s current-account surplus — a measure of its financial transactions with the rest of the world — reached an estimated $250 billion, or 9 percent of gross domestic product. This is unprecedented for an economy of China’s size. Chinese trade data for the first nine months of 2007 show its trade surplus grew by 75 percent from the previous year; that will push the current-account surplus to a stratospheric 11 percent of GDP. (A weak currency tends to promote exports by making the goods a country sells relatively cheaper in overseas markets.)

U.S. politicians and media focus specifically on America’s bilateral trade deficit with China, which stood at $233 billion in 2006, according to the U.S. government. As a result largely of massive foreign-exchange intervention by the People’s Bank of China (the central bank), China’s international reserves surpassed $1.4 trillion in August. The soaring increase in reserves lends credibility to charges that China’s government is manipulating the exchange rate to boost exports.

Why China Will Not Allow a Faster Revaluation

China’s currency policy is of intense interest to much of the world, but it poses important questions for China’s leaders as well. As exports flow out of China, foreign currency flows in, which the central bank converts to renminbi. This has made funds cheap and available in China, contributing to overinvestment — and a red-hot economy. The PBC tries to damp the inflationary effects by issuing bonds to mop up excess cash in circulation. This works, but only to a point. In the end, the flood of capital pouring into China is driving investment demand to dangerous levels.

There also is a widespread fear in China that a strong appreciation of the renminbi would hurt exports. This is a particularly sensitive issue for the government because low-margin, export-oriented companies — especially those in the garment and textile sectors — are major employers. China must create millions of new jobs each year just to absorb the increasing supply of workers. Without a steady source of new jobs, the risk of civil unrest will rise sharply.

But if those arguments support China’s case for an undervalued currency, what about the damage it does to manufacturing in the United States and Europe, and the jobs it destroys? Wouldn’t a faster revaluation of the renminbi protect U.S. households? No, on both counts. The average Chinese worker was paid around $1.35 an hour in 2006, compared with $24.50 an hour in the United States. Even adjusting for different skills and infrastructure in both countries, a sharp rise in the value of the renminbi would not come close to eliminating the gap in labor costs. Moreover, if costs in China became too high, manufacturers would not return to the United States but would simply move to other low-cost countries, such as Vietnam. That said, political relations between the United States and China will be determined to some extent by Beijing’s willingness to give ground on the exchange rate.

What Is the Government’s Strategy?

China’s government has long said its goal is to let the renminbi move with market forces, but Beijing has taken only cautious steps in this direction. The biggest move came on July 21, 2005, when the authorities revalued the currency by 2.1 percent. They also decided to manage the value of the renminbi against a basket of currencies rather than against the U.S. dollar alone (although it was clear the dollar would continue to be given particular weight). The authorities kept the existing trading bands of 0.3 percent on either side of a central rate against the dollar (with the closing rate of the previous day becoming the central rate of the next day), but they started to use this range slightly more actively. In May 2007, the authorities widened the permitted daily trading band to plus or minus 0.5 percent.

Although the band may sound small, it theoretically allows an appreciation of more than 100 percent a year. The government, of course, has been far more conservative than this, initially allowing only slight movements in the exchange rate. In 2006, for example, the exchange rate appreciated by just 2.6 percent against the U.S. dollar. Since the start of 2007, however, the pace of appreciation has accelerated markedly, to an annualized average of 5 percent a year. Although the appreciation has coincided with a period of U.S. dollar weakness (the renminbi has actually depreciated against the euro this year), it does appear that China is more confident that its economy and exporters can withstand the effects of a stronger renminbi.

Next Steps

We expect China to allow the renminbi to appreciate against the U.S. dollar by around 5 percent in both 2008 and 2009. But the exact pace will depend on a number of factors, and there are several reasons why the currency could appreciate more rapidly than most economists expect. One important issue will be the success of the central bank’s efforts to mop up excess cash in the economy. Although these efforts have been partially effective, there have been times when the PBC failed to curb the growth of money in the economy. Mopping up the surplus cash will become even more difficult as the domestic financial system becomes more sophisticated and as a rising number of investors find ways around restrictions on international capital flows.

Another risk is that the bonds issued by the government to soak up surplus capital will create budgetary problems. In most emerging-market economies, the interest rates that government authorities pay on bonds are much higher than the returns they get on their holdings of foreign reserves (most commonly U.S. Treasuries). So far, China’s situation has been different because the interest rate on central-bank mop-up bonds is very low. But with U.S. interest rates on a downward trend, and Chinese rates continuing to rise, the cost to the central bank of soaking up the flood of extra money will rise.

The state of Sino-U.S. relations also will affect the pace of renminbi appreciation. The U.S. political establishment and media have become obsessed with the trading relationship with China. The United States has a number of levers it can use to try to persuade China to revalue its currency more substantially. Without breaking World Trade Organization rules, the United States could introduce tougher measures against what it considers unfair trading practices by China. Moreover, China will be reluctant to provoke the United States in ways that could affect security policy. So, despite China’s deep reluctance to cave in to U.S. pressure, Beijing probably will permit further currency appreciation, though at a slower pace than Washington would like.

Exports Will Remain Strong

In any event, currency appreciation won’t necessarily slow China’s export machine, though a significantly stronger renminbi will undoubtedly make trading conditions tougher for some industries. Much of China’s export growth is driven not by small advantages in competitiveness, but by rapid expansion of manufacturing and the country’s ongoing adjustment to freer trade policies. This process is a direct result of China’s WTO entry. A decade’s worth of massive inflows of foreign direct investment into China’s export industries also has played a major role.

Given the country’s size, and the rapid rise in manufacturing capacity, China will continue to expand its share of world markets for some time. That’s bad news for political relations between the United States and China, but ultimately good news for consumers and businesses as China becomes more fully integrated into the world economy. A revaluation of China’s currency, though, is an important and necessary part of that adjustment process, and would do much to remove some of the weak points in the global economy.

Gareth Leather is an editor/economist who covers China for the Economist Intelligence Unit. Jan Friederich, a senior editor/economist in the Economist Intelligence Unit’s Hong Kong office, contributed to this report.

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