China’s Currency Skirmish

October 14th, 2010

Chinese Yuan | Source: Flickr, Brad & Ying

There’s been a lot of chatter about the yuan lately.  Well, honestly there’s been a lot of chatter about the yuan for a lot of years.  For over a decade, China pegged the yuan, which is the basic unit of the Chinese currency called the renminbi (yes—confusing), to the U.S. dollar.  The Chinese government sets its ideal exchange rate by buying foreign exchange with yuan, thereby increasing the number of yuan per dollars in the global market.  This keeps the ratio of yuan to dollars high, which means the exchange rate is artificially low (again—confusing—no one ever said international finance is straightforward).

China keeps its currency artificially low to make its exports artificially cheap, which means more American buying and more Chinese manufacturing, jobs, and economic growth.  Americans don’t like this policy because it means a wider U.S. trade deficit (exports minus imports).  A lot of people think of exchange rates, and even the trade deficit, as rather abstract and sometimes even meaningless.  They’re not.  C. Fred Bersten, director of the Peterson Institute for International Economics, recently argued a 20% rise in the yuan’s value would translate into an additional 500,000 American jobs.

Over the years China has promised to allow its currency to appreciate, particularly after the rest of the world got angry.  And as you can imagine, the recession has put everyone on edge, which has meant a lot of angry diplomats in China. After some intense pressure from the Obama administration this summer, China made a serious commitment to allow its currency to appreciate and a lot of celebrating ensured.  While it’s fair to point out the yuan has risen against the dollar in recent months, it is also fair to note that the yuan remains severely undervalued, likely by as much as 15 to 20%.  There are competing views on this, but a lot of intelligent people argue the whole promise was a bit of a sham to placate the American government.

In the last few weeks America’s patience has waned.  In September the House of Representatives took a hard line, voting 348 to 79 to give the Obama administration the authority to retaliate by imposing tariffs on Chinese imports.  The U.S. midterm elections have likewise seen a significant upward tick in criticism among campaigning politicians, who argue China’s trade practices are unfair.

A lot of economists have balked at these moves.  Today The Economist magazine warned of a “currency war” (or worse yet, a trade war) if the world doesn’t “keep calm.”  In this morning’s International Economic Bulletin, published by the Carnegie Endowment for International Peace, Uri Dadush alerted us that a “growing threat of trade and currency wars hung in the air at the IMF-World Bank Annual Meetings last weekend.”  Both articles argue for a cool-headed multi-lateral solution involving the IMF.  Both articles also—correctly—point out that potential currency wars are a global issue, with many countries with competing interests and suffering economies involved.

“Currency war” can sound scary to non-economists.  In reality a currency war is a lot less scary than a trade war, though it’s not obvious.  A currency war occurs when several countries take actions like China has, and all try to depreciate their own currencies, to stimulate economic growth.  The result is a flood of liquidity (money) into the world economy as these countries buy foreign exchange.  That’s not necessarily a bad thing.  In fact, some economists have even argued a currency war could be “just what the global economy needs.”

Reality falls somewhere in between these two extremes. It is unlikely a currency war would reap the benefits these economists have espoused.  At the same time, however, I am skeptical of the doomsday scenarios portrayed by economists on the other end.  One thing is for sure, though.  The tension is going to get worse before it gets better.  Just this morning the U.S. Bureau of Economic Analysis announced there has been a sharp expansion in the U.S. trade deficit.  This news will not be well-received by the Obama administration, which has hoped to double U.S. exports in the next five years.  Though I can’t imagine there will be an all out currency war á la 1930s, I’d bet my money on continued currency skirmishes.

One more observation, though.  From a global perspective, China’s exchange rate policy is more damaging to other developing countries that export similar commodities—where labor costs are also low—than it is to the United States.  By undervaluing its currency, China has a comparative advantage over these other nations, possibly stunting their economic growth.  Though the current political atmosphere in the recession-battered U.S. is inward-looking, it would do the world well to remember that China’s currency policy is not only causing grief for Americans.  It’s detrimental from a development standpoint, as well.

Written by Ann Hollingshead

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