Wealth of Nations August 2005

Beijing Has Budged on the Yuan. It Doesn't Really Help.

Both China and the United States need to remember that good economic policy starts at home.

The White House has been pressing Beijing to revalue China's currency, the yuan, for quite a while. Last week, it got a little of what it had asked for. Beijing announced a new currency-management system, and as part of that reform increased the yuan's value by a little more than 2 percent against the dollar. The White House greeted this change as a step in the right direction. But a few months from now, is America going to like the results? Maybe not.

The yuan was certainly overvalued before last week's change—and because the revaluation was tiny, it still is. Estimates vary, of course, but most analysts reckon that the currency would need to rise by 25 percent (some put the figure as high as 40 percent) to control inflows of foreign capital, brake the Chinese economy's over-rapid growth, and stabilize global financial markets. As the Bush administration sees it, a big appreciation—much bigger than 2 percent, for sure—was needed to make Chinese exports to the United States more expensive and American exports to China cheaper. A large rise would have helped to balance America's trade, buoy its manufacturers, and lessen the country's need to keep borrowing so heavily from abroad.

All of which seems to make sense. If China has at least made a start in pushing its currency up, what's the problem? There are two. The first is that China's economic relations with the United States are distracting Congress, the White House, and America at large from what the United States itself needs to do to protect its living standards: China is not the main reason why American consumers and businesses face big economic risks over the next year or two. The other problem is that China may be unable to manage the process it has embarked on quite as well as it thinks. Its timidity in choosing such a small appreciation of the currency could backfire, to everybody's cost.

To listen to some of America's politicians, the country's awesome trade deficit and the foreign borrowing needed to finance it are all a Chinese plot. China is pursuing a mercantilist trade policy, deliberately underpricing its exports (by means of the undervalued yuan, and in other ways) to hammer American manufacturing down. If China could be persuaded, or forced, to trade fairly, America's trade deficit would come under control and its manufacturing base would revive. All would be well. So goes the argument.

Well, China's regime is mercantilist—that much is true. Its economic policies are designed to promote exports, come what may, even at the expense of domestic living standards. (The counterpart of underpriced exports is overpriced imports, hence lower real incomes for Chinese consumers.) But it is worth noting that in the short term, at least, this policy can hardly be said to hurt the United States. In fact, at first blush, it makes America better off.

When a country subsidizes its exports through an overvalued exchange rate, other countries are well advised to take advantage and snap up the goods while they can. Odd as it may be for the Chinese, who are still very poor, to be transferring great slabs of their income to Americans, who are very rich, there is little reason in the first analysis for Americans to object.

And the deal is even better than this, of course, because America's trade deficit, which results only partly from trade with China, is being financed on amazingly advantageous terms. China's decision to keep its currency cheap has obliged it to lend vast amounts of dollars back to the United States, which Beijing has done by adding American government debt to its burgeoning foreign reserves. That debt pays about 4 percent a year. In other words, America has been buying underpriced goods from China, using credit extended by China at bargain-basement interest rates. This is the fabulous deal (fabulous for America, that is) that has Congress in a rage over Chinese perfidy.

It is true that the deal carries a downside for America. The pressure on American manufacturing is one drawback—but jobs in that part of the economy are under stress in any event, mainly because of labor-saving innovation. Greater demand for American exports in the rest of the world would help a bit, so a well-managed yuan revaluation would be welcome, but this would not stop the long-term decline of American manufacturing jobs. And even a big revaluation of the yuan might not spur American exports to China by all that much: Demand in China for imports would rise, all right, but much of that expansion in demand would be met by other countries.

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