TCS Daily


Chinese Puzzle

By Desmond Lachman - January 19, 2005 12:00 AM

Don Evans, the outgoing Commerce Secretary, is to be applauded for his blunt warning to China on its exchange rate policy. On his recent visit to Beijing, Mr. Evans put China on notice in no uncertain terms that it should not expect U.S. markets to stay open indefinitely if China persisted in manipulating its currency.

One must hope that the U.S. administration now follows through on Mr. Evans' lead by keeping up the pressure on the Chinese exchange rate issue. This should be done not only for America's sake but also in China's own long-term interest.

At the heart of China's troubled trade relations with the United States is China's reluctance to change its seven-year-old dollar exchange rate peg at the rate of 8.28 renminbi to the dollar. By maintaining this peg, China has unfairly gained substantial international competitiveness at the expense of its main trade partners. It has done so both through maintaining very low domestic wage and price inflation as well as by allowing its currency to slide down together with the dollar against other major currencies. As a result, academic estimates now suggest that China's currency is undervalued by anywhere between 20 and 30 percentage points.

China maintains its currency peg through having the Bank of China engage in massive and persistent U.S. dollar purchases in the currency market. At present, the Bank of China is buying dollars at the staggering rate of around $180 billion a year in order to prevent the renminbi from otherwise appreciating against the dollar. In reflection of these purchases, China's international reserve holdings are now over $500 billion, which exceeds by a wide margin a level that China might need to reasonably protect itself against undue exchange rate swings.

China's improved competitiveness has fueled a veritable export boom that has substantially improved China's balance of payments. On the back of export growth in excess of 35% a year, China now runs an overall basic balance of payments surplus of around 2½ percentage points of GDP. More sensitively for its relations with the United States, China now enjoys a bilateral trade surplus with the United States of the order of $160 billion. This latter surplus accounts for almost one quarter of the United States' present record trade deficit, which is causing so much concern in global currency markets.

An immediate and significant appreciation of the Chinese renminbi would be extremely helpful in assisting the United States address its present very large external payment imbalance. In and of itself, such an appreciation would help reduce China's present alarming trade surplus with the United States by discouraging exports to the U.S. market. In addition, it would let other Asian countries allow their currencies to appreciate against the dollar without fear of losing market share to the Chinese. This would relieve the euro of the enormous upward pressure to which it is now being subjected as the combined result of the enormous U.S. payment imbalance and the lack of Asian currency flexibility.

While a renminbi appreciation would clearly be in the interest of the global adjustment process, it would also be in China's own long-term interest for at least three reasons.

        1.     It would substantially reduce the risk that U.S. and European 
               markets would be closed to Chinese exports in response to
               unfair Chinese competition. 
        2.     It would assist China in combating the present overheating of its 
               economy, which, if unattended, would result in higher 
               inflation and an erosion of competitiveness. An appreciation 
               of the currency would obviate such overheating both by 
               reducing pressure on China's traded good sector as well as 
               by allowing the Bank of China to follow a more independent 
               monetary policy than it can do under its present fixed 
               exchange rate regime.
        3.     It would facilitate an increase in Chinese domestic 
               consumption and investment, as China redirected its large 
               savings away from financing United States profligacy 
               towards financing the Chinese domestic economy.

To be sure, the Chinese government will resent outside pressure upon it to revalue its currency. However, if left to its own devices, the Chinese government will opt for the status quo. It will do so because the status quo does have the advantage of immediately generating jobs in the Chinese export sector even though this might be achieved at the expense of building up serious longer-term problems for the Chinese economy down the road.

China's reluctance to appreciate its currency might be understandable from China's short-term perspective of wishing to generate employment. However, it is asking too much of the rest of the world to tolerate such Chinese reluctance when it is both damaging to the world payment system and inimical to China's own longer term economic interests. For these reasons, the time would seem long overdue that the U.S. Administration to stop tiptoeing around the Chinese exchange rate issue and start putting real pressure on China to move towards a more flexible exchange rate system.

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