Four years ago, China figured prominently in the disaster scenarios of some international economists. At the time, South Korea, Thailand, Indonesia, and Russia had all suffered severe currency crashes--and contagion was raging through South America. As a result, China's once-booming export machine sputtered to a near-halt, and its manufacturers were pleading with the government to do something. What would happen if China were to sharply devalue its currency to boost its competitiveness? The result, economists worried, would be another devastating round of devaluations around the world that would exacerbate the global financial crisis. Beijing thought long and hard. In the end, it decided to keep the yuan fixed at 8.28 to the U.S. dollar, to the great relief of the outside world.
These days, Beijing again is coming under pressure to do something about the yuan--still valued at 8.28. But now it faces an entirely different conundrum. Trading partners such as Japan and the U.S. are urging China to let its currency appreciate. Why? Because Chinese factories are flooding the world with cheap goods, everything from televisions and DVD players to bicycles and children's pajamas. At a time when most of the global economy is on its knees, Chinese exports have rocketed by 20% so far this year, while its economy is expanding by nearly 8%. In China itself, overproduction has helped push industrial prices down by 7% over the past five years and retail prices by 10%.
To most U.S. consumers, of course, this is a blessing. Made-in-China products have helped keep inflation at bay in the U.S. And China's rise as a manufacturing power has cemented its relationship with the rest of the world.
But a growing minority of economists and policymakers are arguing that a deflationary China poses a real threat to the world. "China's prices are becoming global prices," Morgan Stanley economist Stephen S. Roach wrote in a recent report. Already pricing power over the past decade has collapsed for many consumer-electronics firms, apparel makers, and others. And even though few American producers compete with Chinese goods, Chinese manufacturers are rapidly moving up the food chain into semiconductors, telecom equipment, and other sophisticated digital devices. If the Chinese start dominating these industries, some fear robust pricing will never return to these sectors.
Chinese prices are already causing imbalances in the developing world. Mexico is seeing the flight of whole industries to the mainland. New manufacturing investment has plunged in most of Southeast Asia. The Japanese are already exploring exporting autos from China. Meanwhile, an influx of cheap Chinese consumer items and foods is raising hackles from Japanese producers. Haruhiko Kuroda, Japan's vice-finance minister for international affairs, warned in mid-November that "China will be exporting price deflation to the other Asian countries" as it produces more sophisticated products.
Kuroda's solution: Revalue the yuan by an unspecified amount. Chinese Finance Minister Xiang Huaicheng says Washington is starting to push similar advice. The idea is to make China's products more expensive, which in turn would curb exports.
If only it were that simple. China's competitiveness is so strong that it could easily compensate for a moderate rise in the currency. The supply of $100-a-month Chinese labor is virtually inexhaustible. And $50 billion in annual foreign investment is pouring into China, much of it going to build state-of-the-art factories for U.S., Japanese, and European multinationals. That money is upgrading Chinese industry and boosting productivity by 4% annually, according to the Bank of China.
Another point: A stronger yuan would just make it cheaper for the Chinese to import materials and machinery--which they would turn into products for export. The Chinese would simply pass on the savings from cheaper import costs in their products.
It would take a surge in China's currency on the order of 25% to make much of a difference. But that could spark a financial crisis in China: A drop in exports would wipe out the weakest producers and hammer the banking sector, which is already shouldering some $700 billion in bad loans. A social crisis could well follow, as millions join the swelling ranks of China's unemployed.
It's not even clear if floating China's currency would result in a stronger yuan. Some analysts say that, based on China's huge bad loan problem, the currency should be weaker than it is.
Even Americans are aware of this risk of revaluing. During a recent visit to China, former U.S. Federal Reserve Chairman Paul A. Volcker warned that revaluing the yuan would invite a frenzy of speculation that could be "destructive to economic development." China, he added, "ought to stick with its policy of maintaining stability with the U.S. dollar."
What's more, some argue that other factors are amplifying the China effect. Even though 16% of Japan's imports come from China now, vs. 6% a decade ago, that is still only equal to 1.6% of Japan's gross domestic product, estimates Goldman, Sachs & Co. Managing Director Fred Hu. That's keeping retail prices tame. But the real cause of deflation in Japan is Tokyo's flawed monetary policy. Its financial mandarins have not been able to stimulate business investment or consumer spending. In fact, China may be helping here. Marcus Noland of the Institute for International Economics notes that in those sectors of Japan's consumer economy where Chinese imports are lowering prices, consumption is actually rising. "This is increasing real incomes in Japan," notes Noland. In the U.S., meanwhile, falling import prices "are beneficial for us in a macro sense," he adds.
China's export juggernaut will certainly mean plenty of disruption for the global economy. But don't look for quick solutions. China deflation won't go away until the flood of workers from farms to factories slows--a process that will take decades.
By Mark L. Clifford in Hong Kong