China's dollar peg is distorting prices, with potentially disastrous consequences for the world economy. Will China give way and let the yuan float? Simon Wilson reports.
China saw a 46% surge in exports in the year to February, lending fresh weight to complaints that its currency is undervalued. It follows recent predictions by several economists, including 'Doctor Doom' Nouriel Roubini and Goldman Sachs' chief economist Jim O'Neill, that China is set to relax or remove the renminbi's unofficial dollar peg. This has been in place since July 2008.
Most analysts agree it undervalues the renminbi (or 'yuan') by around 25%-40%. Currency traders got excited last weekend when the governor of the People's Bank of China, Zhou Xiaochuan, hinted that a revaluation – or least appreciation – was on the way. Zhou said the currency peg was a "temporary" policy for dealing with the financial crisis. But his remarks seemed to contradict more non-committal comments from other senior figures, including the commerce minister.
Why is a fixed dollar peg a bad thing?
The most fundamental argument in favour of genuinely free-floating currencies rests on a basic tenet of market economics: that if you distort prices you distort the overall allocation of resources, leading to inefficiency and bigger trouble down the line.
Whether it is consumer goods, assets such as equities or bonds, or national currencies, the 'price mechanism' is an essential gauge by which households and firms make spending or investment decisions.
If those decisions are not based on true demand and supply, then bad decisions get made. In this case, the Chinese government is holding its currency at an artificially low price to keep its exports cheap – a distortion that could have dangerous implications for the entire global economy.
Why does it matter so much?
For many years, China's exchange-rate manipulation didn't matter much. Indeed, in the aftermath of the Asian crisis of 1997, China won international respect for maintaining its dollar peg (held at 8.27 RMB/dollar until 2005), in effect leaving the renminbi overvalued while neighbouring economies undertook competitive devaluations.
The Chinese currency only became obviously undervalued in the years that followed, as first the technology-led stockmarket bubble and then China's 2001 entry into the World Trade Organisation fuelled a surge in investment and exports.
Then, as the dollar began falling against other floating currencies in the years before the 2008 banking crisis – and the renminbi with it, despite the largely cosmetic 2005 decision to let it float within a narrow band – the value of the renminbi became even more clearly out of line.
What about more recently?
This perception that the renminbi is undervalued has only grown since it was once again pegged to the dollar in July 2008. China's economy is now powering ahead with 8% growth rates, and its foreign reserves last year surged 23% to $2.4trn.
This is a problem, as is often argued by President Obama and many US pundits, because an undervalued currency gives China an unfair advantage when it comes to exports and manufacturing and so is a none-too-subtle form of protectionism.
But of course, this is precisely why China is less keen to revalue – its reliance on exports means that any significant rise in the renminbi could hurt economic growth and, more importantly for Beijing, push up unemployment.
And as Andrew Batson in The Wall Street Journal points out, when Japan let the yen appreciate under US pressure in the mid-1980s, the resulting slowdown in growth "pushed the government to boost spending and lower interest rates. A real-estate bubble and years-long slump followed."
So why should China let the renminbi rise?
Unemployment is a big concern for the Chinese government. But so is inflation, which is an equally big threat to social stability. Consumer prices rose at an annual rate of 1.5% in January. It might not sound much, but prices are expected to continue rising in the coming months.
China can only keep its currency pegged to the dollar by printing money to buy greenbacks, and all those billions of renminbi ultimately feed back into the real economy – chasing assets, creating bubbles and stoking prices.
A stronger currency would help contain inflation on two fronts. It would cushion the impact of rising import prices; and it would give the central bank more flexibility to raise interest rates without attracting 'hot money'. China also recognises the need to rebalance its economy in favour of domestic consumption: revaluation would help that, but it's a big risk when its export markets are already threatened by sluggish demand.
Whatever it decides, the timing and extent of any strengthening are likely to be dictated by domestic stresses, rather than mounting calls for new tariffs on Chinese imports by US senators.
What will China do?
A large, one-off revaluation would please economic purists, but seems an unlikely move for China's cautious leaders. On the other hand, a resumption of the gradual appreciation of the renminbi against the dollar (the trend seen between 2005 and 2008) also presents difficulties.
This would be likely to attract inflows of 'hot money' – speculative currency flows in search of a one-way bet – likely to frustrate Beijing's efforts to control domestic asset- and consumer-price inflation.
Some economists, such as Bank of America-Merrill Lynch's China specialist Ting Lu, believe China's best bet would be to benchmark the renminbi against an undisclosed basket of currencies, which is similar to the system used by Singapore.
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