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A Rising Tide for Floating the Yuan

By David Ethridge Topic A these days for economists around the globe is China's currency peg to the U.S. dollar. Finance officials from the Group of Seven industrialized nations and the International Monetary Fund, and most recently, U.S. Treasury Secretary John Snow in a July 29 TV interview, have called on China to loosen its official peg of its currency, the yuan, to the dollar. It has been fixed at around 8.28 yuan per greenback since 1995.

The reason? With its foreign exchange so tightly tied to the dollar, China appears to be keeping its currency artificially weak, the better to pump up exports. That has led other Asian exporting nations to respond by buying dollars -- thereby driving down the comparative values of their own currencies -- in order to stay competitive. And while the pressure mounts for China to relax the yuan peg, so far, the Middle Kingdom is showing little sign that it's eager to cooperate.

The tethered yuan also has to be on the minds of Alan Greenspan & Co., since a weak yuan arguably exacerbates disinflation (a decline in the rate of inflation) in the U.S. through lower import prices. That, in turn, is making U.S. industries like textile and furniture outfits especially upset, as cheaper imports from China and other Asian nations threaten domestic jobs and the manufacturing base. Now, Congress is getting into the act, with a bipartisan group of senators asking Snow to investigate if China is manipulating its currency at the expense of U.S. exporters.

PRESSURE MOUNTS. For now, this outcry for a yuan revaluation is causing an inflow of speculative capital back into China, resulting in a rapid rise in its money supply (see BW, 8/4/03, "Should China Revalue? Soon, It May Have No Choice"). But Beijing doesn't necessarily have to address the currency issue, at least not now. It could loosen ownership rules on foreign assets to allow more legal outflows of money from the country.

Still, the foreign-exchange markets are increasingly speculating about the potential for China to move to a more flexible exchange-rate stance. Snow first spoke of a possible rethinking of the Chinese peg in June. This followed direct calls for an upward revaluation in the yuan by Japan and other Asian countries trying to stay competitive with China as low-cost exporters.

The IMF's economic adviser has called on China to allow a stronger currency given its mounting trade surplus and fast domestic growth. And European Community President Romano Prodi has also expressed concern that global trade imbalances would be hard to correct unless China loosens its peg -- and other Asian countries refrain from buying dollars to stay even.

Other European officials have joined the fray, suggesting that a stronger Chinese currency would help in the rebalancing of trade surpluses. So far, China allows only that it is studying several options for dealing with huge and rising foreign exchange reserves -- now at a record $340 billion.

ELECTION ISSUE. The implications for the U.S. economy are enormous. The bulk of the U.S. trade deficit is with Asia, and increasingly with China. Indeed, at more than $100 billion, China is running the largest current trade surplus of any nation with the U.S. And that figure is likely to rise further this year. A weaker dollar is seen as one way to help the U.S. recovery by boosting exports and foreign-based profits until a sustainable return to growth can be achieved.

Unfortunately for export-hungry American manufacturers, while the value of the U.S. dollar has fallen at double-digit percentage rates vs. major European currencies over the past 12 months, its decline was far less in relation to the Asian currency bloc. The Fed's "broad" trade-weighted dollar index is off less than 5% so far in 2003, with key Asian currencies accounting for nearly 40% of the overall basket.

If China and the rest of Asia aren't careful, Asia's pegging of currencies to the dollar -- whether directly or indirectly, like Japan and Korea -- looms as a possible political issue in next year's U.S. Presidential election. If China doesn't relax its currency peg, lower requirements for dollar reserves held by China -- the second largest holder of U.S. Treasury debt -- could also eliminate a sizeable source of funding for the U.S. budget deficit. That will make deficit hawks on both sides of the political aisle in Washington howl.

STEEL BALANCE. U.S. manufacturers and industries bedeviled by cheaper foreign imports will likely pressure the White House even harder to drop the "strong" dollar mantra or take a tougher stance with countries manipulating their currencies for export gain. The National Association of Manufacturers considers China's monetary stance a major issue in the coming months, while the Coalition for a Sound Dollar (an association of several U.S. business and commodity trade groups) is drawing attention to Asian countries that keep their currencies undervalued. In the eyes of U.S. manufacturers, China has now replaced Japan as the chief source of their woes, unfairly taking market share through an artificially weak currency.

It isn't surprising they would take that position. Just look at the steel industry. Over the past eight years, China's share of global steel production has grown from about 15% to almost 30%, double the U.S. and Japanese share and slightly greater than Europe's. And a trade group representing U.S. textile and apparel makers claims that an undervalued yuan could allow China to capture up to 75% of U.S. markets in 2005, after quotas limiting Asian imports expire at the end of 2004. Chinese sales of textiles to the U.S. rose over 60%, to $3.1 billion, in 2002.

Amid growing political pressure, U.S. Commerce Secretary Donald Evans said his department will soon hold roundtable meetings with manufacturers -- and he promised aggressive action to make China adhere to its commitments as a member of the World Trade Organization and further reduce trade barriers.

STRATEGIC ALLY. Ultimately, the challenge for Team Bush is to get China to become more accommodating, without provoking renewed tensions with the Middle Kingdom. Washington especially needs China's help in dealing with North Korea, which is openly flaunting its nuclear-weapons development programs.

Thus, Snow & Co. are likely to stick to the line of repeatedly asking China for a more flexible currency regime -- but not actually pushing for an outright revaluation of the yuan. Beijing may budge a bit, too. But it may not be enough to provide U.S. manufacturers with the relief they're seeking -- or stem the rising tide of job losses in the industrial sector. Ethridge is a research director for MMS International

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