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Why China should revalue the yuan

By Peter Morici
web posted June 25, 2007

Not since the United States floated the dollar in the 1970s and threw the Bretton Woods system on the scrap heap of history has the management of exchange rates so captured the attention of economists and national politicians as China's undervalued yuan does now.

Then, as now, all manner of polemics and the weight of established authority argued that governments should manage currency-exchange rates, much like they attempt to fix prices, for example sugar or petroleum, to supposedly serve the greater good.

We hear about China's weak financial system, the pent-up demand for dollars in China, and the need for exchange-rate stability in developing countries. However, we should always be wary when professors, who enjoy the absolute protection of tenure and corporate leaders and bankers, whose investments benefit from government meddling in markets, argue that prices should be regulated in the public interest.

China's financial system would be no more rickety or vulnerable if the exchange for the yuan were maintained at a level more consistent with underlying supply and demand in foreign-exchange markets.

As things stand, thanks to China's huge trade surplus and inward foreign investment, the international demand for yuan greatly exceeds the supply. To limit market appreciation to less than 5 percent a year, Chinese monetary authorities print yuan to purchase dollars and other hard currencies valued at about $300 billion, annually. Otherwise, the value of the yuan against the dollar would rise at least 40 percent to about 4.5 from its current rate of about 7.6 per dollar.

In turn, Chinese authorities purchase U.S. Treasuries and other securities to earn interest on their hoard, and sell yuan-denominated bonds domestically to soak up the excess liquidity these yuan sales create and head off inflation. This increases Chinese savings and transfers purchasing power to, and lower savings in, the United States.

Through this process, Beijing encourages overinvestment in manufacturing export industries and excessive urban development, stokes a speculative bubble in China's stock market, and provokes inflation in global oil markets. (China manufacturers use energy much less efficiently than do competitors making similar products in the West.)

All this causes underinvestment in Chinese domestic needs, such as decent sanitation and clean water in rural areas, and exacerbates income inequality that undermines the social stability the Communist Party so earnestly seeks to preserve.

These processes also exacerbate job losses in manufacturing and widens economic inequality in the United States and other industrialized countries, thereby undermining political support for the World Trade Organization system of free trade that has so benefited China's economic progress.

One of the curious accomplishments of the Bush Administration and other defenders of this alchemy has been to label as "protectionists" U.S. critics that advocate a market-determined yuan.

What a novel idea for a Republican administration - campaigning for free currency markets is a protectionist conspiracy!

Equally remarkable, these defenders of rigged markets have enlisted the conservative press to ridicule anyone who proposes meaningful U.S. responses to the harmful effects of Chinese mercantilism on the U.S. economy.

Clearly, it would ease Sino-American relations if China revalued the yuan to, say, 6 or 6.5 per dollar. But once China revalued substantially, its policy of woefully slow yuan appreciation would no longer be credible among investors. Pressure to keep revaluing the yuan upward would be incessant.

Right now, thanks to the yuan peg and inward investment, China must purchase dollars and other currencies at a pace equal to 10 percent of its gross domestic product and about 25 percent of its exports. That requires Beijing to work quite hard to find enough domestic investors to purchase yuan denominated bonds to increase domestic savings by that amount and head off a bout of liquidity-driven inflation. The policy would collapse if the government could no longer sell ever-larger amounts of yuan-denominated bonds to recapture all the yuan it prints to buy dollars and other hard currencies.

A stated policy of revaluing the peg to a level that does not require persistent one-sided intervention through large purchases of dollars would be credible and welcomed. Revaluing, for example by 10 percent, initially, and then permitting the yuan to rise 2 percent against the dollar each month, until one-sided intervention was no longer required, would satisfy financial markets and permit the necessary adjustments within the Chinese economy to unfold in an orderly fashion.

What investors need to know is what the policy is and that Beijing is moving the exchange rate for the yuan, in a timely fashion, to a value that is consistent with China's growing competitive strengths.

Remember, the exchange rate is nothing but a price. Sooner or later, when a government fixes prices, someone gets hurt. Often, many ordinary working people get hurt the most. ESR

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

 

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