A Chinese Currency Conundrum

December 13, 2006 Topic: Economics

A Chinese Currency Conundrum

U.S. policymakers should push for China's currency liberalization the way they have its political liberalization—incrementally.

Can Hank Paulson charm the Chinese? As the U.S. treasury secretary opens a "strategic economic dialogue" with Chinese officials on Thursday, this question will undoubtedly be on the minds of China-wary congressmen. Should Paulson-who is to be accompanied by Federal Reserve Chairman Ben Bernanke, U.S. Trade Representative Susan Schwab and other members of the Bush cabinet-return from the talks empty-handed, the U.S.-China economic relationship will likely be tested. But as with its approach towards China's political liberalization, Washington should apply steady but calibrated pressure-accommodating to some degree Beijing's own preference for gradualism.

One trade issue that has already garnered attention is the undervaluation of the Chinese yuan. Chinese fixing of exchange rates, which many think has contributed to a $202 billion trade deficit in 2005, has stoked protectionist sentiments in Congress. Concerns about China's artificially cheap currency prompted Senators Lindsey Graham (R-SC) and Chuck Schumer (D-NY) to propose a 27.5 percent tariff on Chinese goods. The senators withdrew this punitive measure in September, but distrust of China's economic power is still palpable in Congress. If ever put to a vote, the Schumer-Graham bill could still pass; last year it received the support of 67 senators.

Senator Chris Dodd (D-CT)-who will be chairman of the Senate Banking Committee-recently  told the Financial Times that being patient with China is "pretty difficult" when he has to "explain to the American people day after day that a major competitor of ours . . . is still fixing its own rates at a great disadvantage to us." While it may be politically unpalatable to legislators, only Paulson's patient approach will lead to the desired revaluation of the yuan. Congressional calls for a drastic appreciation of the yuan will fall on deaf ears in Beijing and will sour the already tense relationship between the United States and China. Although Beijing's currency policies do contribute to the United States' enormous current account deficit, China is not solely to blame for America's deficit. The United States should look inward and seek to reduce its debt by curbing public and private spending.

Demand for the Dollar

To understand why the yuan's undervaluation grieves policymakers, it is first necessary to comprehend how the Chinese central bank fixes exchange rates. The People's Bank of China establishes the value of the yuan relative to that of a "basket" of currencies, including the dollar. The Chinese central bank allows the yuan's "price" to fluctuate, but within specific limits. The yuan has appreciated 7 percent against the dollar since September, but that is a cold comfort to the experts and policymakers who believe that the currency is undervalued by as much as 30 percent. By maintaining a cheap currency, the People's Bank of China ensures that its exports remain competitive in global markets.

The sale of exports abroad creates massive flows of foreign currency, in particular U.S. dollars, into China. The Chinese central bank eventually purchases almost all of this foreign currency with yuan. To try to prevent inflation, the central bank removes this excess yuan from circulation by dispersing it, in the form of central bank bills, to banks throughout the country. The result of this process is the central bank's inevitable accumulation of foreign reserves. The People's Bank of China reportedly possesses reserves worth about one trillion dollars, approximately 70 percent of which are actually in American currency. The Chinese central bank's exchange rate regime, propped by an ever-growing stock of dollars, ensures that Chinese exports are relatively cheap abroad and foreign imports are relatively expensive in China.

In the end, Chinese stores of dollars, whether public or private, often end up in the United States. Chinese investors, including the People's Bank of China, currently hold $339 billion in U.S. Treasury bonds. Such economic interdependence only serves to complicate any attempt by U.S. legislators to browbeat China into revaluing the yuan.

Easy Does It

Beijing has compelling reasons for controlling its currency's relative value, so congressional China-bashing is not likely to produce results. Fixing exchange rates has allowed China to maintain its export-driven approach to economic development. While a free-floating yuan would foster a sustainable GDP growth rate over the long run, increased exchange rate volatility-in conjunction with the yuan's likely appreciation against the dollar-would put a large swathe of the Chinese economy at risk. Not only would jobs in China's export industries be threatened, but China's poorly run banks would be placed under undue strain.

Furthermore, many within China's political elite view Japan's past economic troubles as confirmation that China's currency policy is on the correct course. These bureaucrats believe that Japan's tinkering with the yen's value, done at the United States' behest, hastened Japan's slide into its prolonged recession. China's central bank chief, referring to the Schumer-Graham bill, noted on September 9th, "Such ‘noises' will not change any of the basic conditions and sequences of China's exchange rate reform." 1  The firm positions of both U.S. congressmen and Chinese officials make anything but a gradual appreciation of the yuan improbable. Therefore, threats to punish Beijing for its intervention in currency markets will only produce mutual acrimony, spoiling prospects for progress on related issues, like intellectual piracy.

Instead of loudly decrying Beijing's currency manipulation, legislators should emulate Hank Paulson's patient approach to China. Being patient does not mean doing nothing; Washington's willingness to accommodate China's baby steps towards greater openness illustrates this point.  

Similarly, the currency problem is not one that can be easily solved before the next election, nor will its resolution neatly correct global imbalances. Congress should recognize that an accurate valuation of the yuan will not eliminate the United States' current account deficit, or even its trade deficit with China.

If the yuan were to appreciate against the dollar, Chinese imports would become undoubtedly more expensive in the United States, and the trade deficit would inevitably decrease. However, according to Council on Foreign Relations economist Douglas Holtz-Eakin, "increases [in the prices of Chinese goods] would probably be much less than the appreciation of the yuan itself" 2, so a currency revaluation might have less of an impact on the deficit than policymakers would like to think.

Policymakers need to acknowledge that China, while the largest single holder of U.S. currency reserves, is not the only country with an undervalued currency. The Economist has  proposed that "Paulson should have gone to the Middle East not China" since oil-exporting countries in this region, awash in foreign money, keep their currencies' relative value tightly tied to that of the dollar.

While the undervalued yuan has contributed to the yawning U.S. current account deficit, America's acquisitive consumers and spendthrift government also bear a good portion of the blame for the imbalance. The current account deficit could be reduced if U.S. households saved more and the U.S. government spent less. While this oft-repeated, obvious suggestion seems simple enough, it appears that neither the government nor the population seems willing to make the sacrifices necessary to reduce their respective indebtedness. Perhaps the speculation about an upcoming recession will prompt U.S. households to stop spending, on average, at levels higher than their incomes.

This does not imply that U.S. policymakers should ignore China's currency manipulation altogether. Since Chinese officials have stated that they hold a floating yuan as a long-term goal, U.S. policymakers should ensure that the Chinese follow through on this statement. U.S. policymakers need to control their protectionist impulses and-taking a cue from U.S. efforts to encourage China's political liberalization-engage the Chinese leadership on this issue.