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It's high time for John Snow to cite China for manipulating the yuan

By Peter Morici
web posted May 8, 2006

U.S. Treasury Secretary John Snow will soon issue his semiannual report on the currency policies of major trading nations. The Omnibus Trade and Competitiveness Act of 1988 requires him to "consider whether countries manipulate the rate of exchange between their currency and the United States dollar for the purposes of preventing effective balance of payments adjustments or gaining unfair competitive advantage in international trade."

Secretary John Snow should determine that China manipulates the yuan to obtain an unfair competitive advantage. Sadly, he will likely again deny sound economics and finesse the issue.

International trade and investment flows best promote global prosperity and progress in developing countries when those reflect comparative advantages and national differences in market-determined rates of return for capital. Exchange rate adjustments are vital for ensuring that national trade and investment balances reflect these fundamentals and promote the efficient geographic dispersion of production.

Absent government intervention, private actors, exchanging currencies to execute trade and investment decisions, would determine exchange rates. Countries importing lots of private capital would see their currencies rise in value, and import more goods and services than they export. This would permit them to both meet consumers present needs and amass the sinew for future prosperity—producer durables, social infrastructure, technology, and managerial know how.

Governments may lower or raise exchange rates by selling or buying their national currencies for dollars. While managing exchange rates may create certain national benefits, chronic undervaluation or overvaluation imposes significant costs on trading partners and risks on the global commercial system.

For example, the 1997 Asian currency crisis was caused by overvalued currencies, such as the Korean won, engineered to allow manufacturers to buy western capital goods and technology on the cheap. These required borrowing dollars to support currency values and betting those loans could be repaid with future export earnings. When bad investment choices and corruption kept export enterprises from paying out as needed, dollar denominated loans could not be repaid and calamity followed. Speculators were tarred but it was the stupidity of finance ministers that precipitated the crisis.

In the 1980s and 1990s, Japan prosecuted a mercantilist assault on European and North American durable goods industries by purposely undervaluing the yen. When rising wages and other costs finally limited export-led development, Japan's economy sputtered, and it has suffered a decade of stagnation.

In 1995, the Chinese government pegged the yuan at 8.28 per dollar. In July 2005, it adjusted that value to 8.11 and announced the yuan would be aligned to a basket of currencies; however it still tracks the dollar closely and is now trading at about 8.01.

China has vast needs for capital and technology and equally impressive development potential. Its economy, lacking an appreciable natural resource such as oil, should be an equally vast recipient of foreign investment. It should enjoy a foreign investment surplus and offsetting trade deficit, as it acquires the machinery of a modern economy and know how. Instead, China has huge and growing trade surpluses, exacerbating the disruptions its integration into the international commercial system naturally creates.

Rapid Chinese productivity growth and large foreign investment inflows should cause the yuan to appreciate. However, Beijing sees the exchange rate as a critical development tool, and consistently sells yuan for dollars to severely limit the appreciation of the yuan against the dollar.

From 2001 to 2005, China's foreign currency holdings increased from $216 billion to about $820 billion, and its trade surplus grew from 1.3 percent to 5.3 percent of GDP.

In 2005, Chinese monetary authorities purchased $206 billion in U.S. and other foreign currencies and securities, about 9 percent of GGP. These purchases create an off-budget subsidy on exports and products competing with imports. Swelling China's trade surplus, these purchases distort investment decisions in China, the United States and elsewhere, and push up the huge U.S. trade deficit.

Clearly, China's currency practices create an unfair trade advantage and are one reason manufacturing is not enjoying the same scale of expansion as the rest of the U.S. economy.

Given China's development status and trade surpluses, this pattern of official reserve purchases may be fairly characterized as currency manipulation. It may not be reasonably characterized as anything else.

Sooner or later, China will reach the limits of its ability to sell cheap goods in the United States. With its surplus of underemployed labor, rising wages won't pose too much of a problem. However, Wal-Mart can only sell so many cheap gadgets, and if China steals too many U.S. jobs, stagnant wages will severely constrain U.S. demand for its products. China's drain on oil and other global resources, and the inflation that creates, is about to preview that phenomenon.

When China hits the wall, its size will make the 1997 Asian currency crisis look like afternoon tea at Buckingham Palace.

Peter Morici is a professor at the University of Maryland School Of Business and the former Chief Economist at the U.S. International Trade Commission.

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