Currency Stalemate at U.S.-China Meeting

As the yuan begins to depreciate against the dollar, Henry Paulson meets with Chinese leaders to encourage continued currency reforms
US Treasury Secretary Henry Paulson (L) meets with Chinese President Hu Jintao during a meeting at the Great Hall of the People on December 5, 2008 in Beijing, China. Pool/Getty Images

Once China de-pegged the yuan from the U.S. dollar on July 21, 2005, the exchange rate issue faded as a major irritant in U.S.-Sino relations. Since then, the yuan, also known as the renminbi or "people's money," has gradually strengthened by more than 20%, to its present level of 6.88 against the greenback. The stronger yuan, along with rising labor costs in China and the cancellation of preferential policies for Chinese exporters, have been pushing factories in the Pearl River Delta (, 3/27/08) region into bankruptcy or overseas to Vietnam, Indonesia, or other emerging markets.

Now controversy over the yuan's exchange rate has reared its ugly head again. After peaking at 6.82 against the dollar on Nov. 28, the yuan has started to depreciate. With China's export growth slowing down to 19.2% in October as consumers in the U.S. and Europe tighten their belts, economists are wondering if China will allow the yuan to weaken even more to boost export growth. After all, the yuan is the only emerging market currency to strengthen against the dollar so far this year, meaning China's exports are losing competitiveness vs. other Asian countries.

Before arriving in Beijing for the fifth Strategic Economic Dialogue on Dec. 4-5, Treasury Secretary Henry Paulson publicly prodded China (, 12/3/08) to maintain a strong yuan. In the two-day talks that covered a host of issues including combating protectionism and cooperating on climate change, senior U.S. government officials emphasized to their Chinese counterparts the importance of continued currency reforms to rebalance China's economy from an export-driven growth model to one more responsive to domestic consumption. "We make the point that continued progress and flexibility [on the currency] is important, and the Chinese side agrees," Paulson told reporters in Beijing on Dec. 5.

Counting on the Dollar

At the same time, China wants the dollar and other major currencies such as the euro and Japanese yen to stay strong to provide some measure of stability in the financial crisis. With the world's economy in the dumps, investors have turned to the U.S. dollar for a safe haven (BusinessWeek, 11/26/08), already sending it up about 20% against the euro."In the past several days, we did see a slight depreciation of the renminbi against the U.S. dollar. I think this is normal," Chinese Commerce Minister Chen Deming told journalists on Dec. 4. "Instead of calling this a depreciation of the renminbi, I prefer to call it appreciation of U.S. dollars."

Whether or not China will heed Paulson's call and maintain a strong yuan remains to be seen. The central bank's third-quarter monetary report, published on Nov. 17, was virtually silent on its exchange rate policy outlook. China's public position has been that it will continue to reform controls on the yuan exchange rate in an "independent, flexible, and incremental" manner. "We will continue to allow the market to play a primary role in setting the exchange rate," Zhu Guangyao, China's assistant finance minister, told a press briefing in Beijing today.

Economists doubt that China will allow the yuan to depreciate against the dollar for too long. In a Dec. 3 research report to clients titled To Depreciate or Not to Depreciate, UBS (UBS) economist Wang Tao pointed out that China is not experiencing massive capital outflows or seeing its current account turn from a surplus to a deficit, both of which would put depreciation pressure on the yuan. Moreover, if China were to depreciate the yuan significantly, it could ignite a chain reaction of devaluations from other Asian countries eager to keep their exports competitive and would likely earn China international opprobrium. "We think China has a very limited scope for sustained CNY depreciation against the USD in the coming year," Wang writes in the research note.

Morgan Stanley (MS) economist Wang Qing adds that the cons of devaluing the yuan would outweigh the pros, such as a boost to Chinese exports. If China were to allow the yuan to devalue, it could trigger a massive outflow of capital from so-called "hot money"—speculative capital that flows between financial markets in search of the highest returns. A devaluation—something China didn't do even during the Asian financial crisis a decade ago—could hurt authorities' plans to promote the yuan as a major international currency in Asia. And Wang writes in a Nov. 24 research report: "With the U.S. Democrats—who tend to take a tougher stance vis-à-vis China on trade issues in general and the renminbi exchange rate in particular—in control of both the White House and Capitol Hill, Chinese authorities may not want to antagonize their U.S. counterparts by devaluing the renminbi, especially when the latter are in the early days in office.—

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