Currency policy weakens China’s economy

By: Christopher Lingle
Source: The Jakarta Post, February 10, 2009

Comments by Treasury Secretary Timothy Geithner in his confirmation testimony before the Senate already strained relations between the Obama administration and Beijing . His willingness to stoke the flames of trade protectionism to insure his appointment is a bad sign and a poor beginning in the management of international relations. But then, he
only parroted the campaign-trail rhetoric of his new boss that had asserted then that China was a currency “manipulator”.

As it is, such statements pander to lawmakers that believe an undervalued yuan gives Chinese exporters unfair advantages that led to US job losses and the US trade deficit. And Geithner’s remarks echo Ben Bernanke’s earlier suggestions that China ’s undervalued currency was an “effective subsidy” to exporters that distorts patterns of production and trade. (By contrast, theTreasury Department of former-president George W. Bush urged Beijing to move to a market-determined exchange rate but did not say that China manipulated its currency.)

Su Ning, vice governor of the People’s Bank of China, pointedly rejected Geithner’s claims. It is surprising that such imprudent statements were allowed to be made after Beijing had cautioned US Secretary of State Hillary Clinton to handle their diplomatic ties with care.

This is a matter of considerable concern to Beijing . If Chinese exchange-rate actions are viewed to constitute a “subsidy”, US officials can ask the World Trade Organization to investigate whether they violate international violate trade pacts.

At the same time, US law would require the Treasury Department to “expedite” negotiations with Beijing to reduce China ’s trade surplus and eliminate “unfair” currency advantage. The US Congress, controlled by Democratic Party operatives that generally oppose free trade,
has already considered anti-dumping legislation.

In all events, the Obama administration must be careful what it wishes for. A sharp rise in the value of the yuan would push up interest rates in America as China ’s and other central bank sold off US Treasuries.

At the same time, consumer prices in the US would go up sharply and the Chinese economy would experience a slowdown, perhaps experiencing a recession. And a sharply-stronger yuan would allow Chinese businesses to acquire US companies and real estate properties.

Such moves would almost certainly ignite the instinctive economic nativism of the Democratically-controlled US Congress.

'For its part, Beijing follows policies that paradoxically undermine its own economy while propping up the US economy by accommodating the pump-priming of America ’s central bank.

Vast stocks of dollars in reserves held by Beijing and Hong Kong as the largest net purchasers of Treasury securities help keep US Treasury bond yields lower than they would be. With so much new federal government debt coming on stream, it is better for interest rates to remain low. China ’s shift from a command economy reflects some of the essential elements of Mercantilism. But Beijing replaced the notion of measuring wealth in terms of gold stocks with a dollar fetish fed by a misguided obsession with export-led growth.

Over two centuries ago, Adam Smith debunked both notions. First, he pointed out that the wealth of a country is measured by its productive capacities rather than stocks of metal bullion. Second, enhancement of wealth works best through trading with other countries due to a counter-intuitive notion that the greatest gains from trade arise from importing rather than exporting.

China ’s neo-Mercantilism inspires it to hold large foreign exchange reserves that create domestic inflationary pressures and allow its public-sector debt to balloon. This occurs because capital controls imposed by Beijing oblige exporters to deposit hard currencies in the central bank in exchange for freshly-printed yuan (usually as bank deposits) or government debt.

Both arrangements eventually become untenable by either generating an intolerable rate of inflation or an unacceptable burden of public-sector debt. These are very high prices to pay to maintain current policies, including a pegged exchange rate.

In all events, the valuation of a currency is only one aspect of the competitive nature of an economy. The bad news is that leaders of countries with stronger currencies must develop the political will to carry out structural reforms or their economies will continue to under-perform.

It turns out that a currency can appreciate while the economy remains sluggish or it can depreciate despite robust growth. But the valuation of a country’s currency is not so much determined by the performance of its economy than by the forces of supply and demand on foreign currency markets.

For a given supply of money, an increase in the production of goods will increase the exchange value of a currency since each unit will buy more goods. Likewise, increasing the supply of money relative to a fixed output of goods will lead to a decline in the purchasing power of money each currency unit buys fewer goods. As such, declarations before the fact that China ’s currency is undervalued are nonsense since it can only be known once all economic players decide where to place their financial assets. The relatively-high rate of growth of China ’s money supply creates substantial underlying pressures for the yuan to depreciate, not appreciate!

Stirring up protectionist instincts that worsen relations with Beijing is a very bad idea for the Obama team. This is especially so since most problems in the US -economy are self-inflicted and policies that attract the ire of American protectionists actually cause more harm to China .


The writer is Research Scholar at the Centre for Civil Society in New Delhi and Visiting Professor of Economics at Universidad Francisco Marroquin in Guatemala.