Should China Allow its Currency to Appreciate?

Post April 2005 China allowed the Yuan to appreciate gradually against the US dollar, but since 2008 China has maintained a hard peg against the USD at 6.8 ensuring that Yuan followed the dollar as the latter depreciated against the yen and euro.

China has emerged as world ace exporter, surpassing Germany in Dec 2009, and has come under scanner to keep its currency undervalued to shore up its economic and trade competitiveness. Beijing's policy of keeping the Yuan weak has helped China become the first key economy to recover strongly from the world financial crisis but at the expense of its key trading partners still nursing the wounds of recession, some analysts contend. The USD has depreciated substantially relative to other currencies since May of 2009. Since the Yuan is tied again to the dollar, the Yuan has depreciated by the same amounts, including 16% against the euro, 34 % against the Australian dollar, 25% against the Korean won, and 10 % against the Japanese yen. This substantially depreciation of the Chinese currency has made many other countries angry at China's policy of locking it to the US dollar.

The US and other countries worry that the undervaluation of the Chinese currency increases the demand for Chinese exports, and reduces China's demand for imports from countries like the US. Since China has largest population, and demand for the US and other countries grows, but the goods are uncompetitive in the Chinese market. The US especially wants to help reduce the high levels of unemployment found in many of these nations. US companies that would like to export more to China are hurt by the maintenance of the Chinese currency at an artificially low value relative to the dollar. As a result, employment by these companies is lower than it would be, so that this may contribute a little to the high rate of US unemployment. But I believe the benefits to American consumers far outweigh any loses in jobs, particularly as the US economy continues its recovery, and unemployment rates come back to more normal levels. This is acting as double whammy for the developed nations which are trying hard to get out of recession: Their imports are increasing and exports are becoming uncompetitive.

The opposite effects hold for China. Their consumers and importers are hurt because the cost of foreign goods to them is kept artificially high. Their exporters gain, but as in the US, that gain is likely to be considerably smaller than the negative effects on the wellbeing of the average Chinese family.

This policy will make the Chinese exports competitive and help China to amass foreign reserves, now more than two trillion dollars, could result in protectionism and even spark a trade war.

According to Purchasing power parity, the Yuan, if allowed to freely float, should trade at 3.8 per 1 USD. So there is no doubt that China is intentionally holding the value of its currency below the rate that would equate supply and demand. By pegging the Yuan to USD, China has virtually adopted the Monetary Policy of US.

With huge pile of foreign exchange reserves, China is investing back in the US in treasuries. The US has little to complain if China wants to hold such high levels of low interest-bearing US government assets in exchange for selling goods cheaply to the US and other countries. China's willingness to save so much reduces the need for Americans and others to save more, but is not differences in savings rates also part of the international specialization that global markets encourage? To be sure, why China is willing to do this is difficult to understand since they are giving away goods made with hard work and capital for paper assets that carry little returns.

One common answer is that China hopes to increase its influence over economic and geo-political policies by holding so many foreign assets. Yet it seems just the opposite is true, that China's huge levels of foreign assets puts China more at the mercy of US and other policies than vice versa. China can threaten to sell large quantities of its US Treasury bills and other US assets, but what will they buy instead? Presumably, they would buy EU or Japanese government bills and bonds. That will put a little upward pressure on interest rates on US governments, but to a considerable extent, the main effect in our integrated world capital market is that sellers to China of euro and yen denominated assets would then hold the US Treasuries sold by China.