Obama and Romney Overstate China Threat

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By Evan Soltas

China-bashing is again in vogue, with both President Barack Obama and Mitt Romney bringing out harsh rhetoric in campaign speeches.

The candidates charge that China uses its large holdings of the dollar, other currencies and U.S. Treasury debt to manipulate exchange rates to its exclusive benefit. By undervaluing the yuan, China gives its exports a low-cost advantage in global markets.

The problem with that argument is that this year it is less and less true. As a result of reforms in Beijing, Chinese currency manipulation is more limited than at any time in the history of the People's Republic.

China is loosening its grip on its currency because it wants the yuan to have a greater role in global markets, if not achieve reserve currency status, economists say. This would require freer and more active markets for foreign exchange of yuan into dollars and other currencies, as well as capital markets in which loans can be made and repaid in yuan around the world.

Today, China doesn't have free markets in foreign exchange or capital. But it is moving toward liberalization in both by gradually unclenching controls.

The country's first step has been to allow a slow and managed appreciation of the yuan, toward the level economists see as its appropriate free-market value. The upward adjustment began in July 2005 and paused from 2008 to 2010 to absorb the shock to exports during the financial crisis. The pace has been slow, with a 23 percent appreciation of the yuan in seven years. That is hardly enough, by most observations, as the yuan remains 40 percent undervalued against the dollar, according to the Economist's "Big Mac index" as of January 2012.

As a result of the yuan's appreciation, Chinese exports are not as artificially cheap as they were a few years ago. Although the Chinese government's industrial subsidies have compensated producers in some cases, the broad cost advantage Chinese exports hold against American domestic producers is shrinking.

The commitment to a fairer and freer exchange rate for the yuan is also seen in the Chinese government's foreign-currency holdings. By buying dollars and U.S. debt, the Chinese government has been able to hold down the value of the yuan -- but data from the central bank, the People's Bank of China, reveals no net change in total foreign exchange reserves over the last year. That marks a major change in policy as compared with a doubling of reserves from 2007 to 2011.

China may no longer be holding down the yuan, but there are other ways for the government to manage the currency, such as by calibrating the expectations of the market. And it is impossible to know the full extent of the Chinese central bank's activity in currency markets.

The People's Bank announces a daily "fixing" of the exchange rate between the yuan and dollar at the start of trading, allowing the exchange rate to fluctuate within a band of 1 percent. The country doubled the width of the band from 0.5 percent in April 2012, creating more room for a viable exchange market for the yuan.

The Chinese government has also taken steps to encourage the international use of the yuan -- the sort of action taken only if committed to the long-term liberalization of the currency. It has supported the idea of loans in yuan for Latin America and the Middle East, hoping to help its manufacturers cope with soaring costs of producer inputs.

Yuan trade settlement -- the volume of deals that are conducted in the Chinese currency abroad -- is expected to boom this year and into the future. At home, China has loosened controls on foreign investment, though these remain tight by global standards. A large foreign market for Chinese capital and currency will increase the use of the yuan while lastingly undermining Chinese control of its value.

The adjustment from a fully fixed currency to a free-floating one is incomplete, and new frictions have emerged. A weakening Chinese economy over the last year has seen a reversal of trends with a small depreciation of the yuan, managed by the People's Bank. The value of the yuan has fallen 0.9 percent against the dollar since its highs in January. A restart to depreciation threatens to raise tension between the U.S. government and Beijing.

Still, China's yuan is a freer currency than ever, and despite some recent backtracking, it seems likely the march to a more liberalized currency will continue. It's easy to blame Chinese currency manipulation for U.S. economic woes, but Obama and Romney's claims are increasingly looking outdated.

Evan Soltas is a contributor to the Ticker. Follow him on Twitter.

Read more breaking commentary from Bloomberg View at the Ticker.

-0- Sep/04/2012 16:45 GMT