LONDON (ResourceInvestor.com) -- Last week saw U.S. Secretary of the Treasury Henry Paulson visit China for high level economic talks. The main topic of conversation was the U.S. trade deficit with China and as a corollary, the relative values of the yuan and the dollar.
The two sides’ opinions on the current pattern of U.S.-China trade clearly differed. Paulson stated publicly, in what the Chinese will have perceived as a most un-diplomatic fashion, that “the rest of the world is going to be impatient, particularly the U.S., and so they (meaning the Chinese government) need to accelerate reform”.
Meanwhile, China’s Vice-Premier Wu Yi dismissed Paulson’s attitude as “not conducive to the sound development of our bilateral relations”, and chastised the U.S. government as “not only having limited knowledge of, but harbouring much misunderstanding about the reality in China”.
From the tone of these public comments we can glean that the behind closed doors exchanges must have been pretty barbed at times.
Paulson and the rest of the Bush administration are grouchy because data published on Tuesday showed that the U.S. trade deficit with China grew 6.1% to a record $24.4 billion in October, and that the deficit with China represented 41% of the total U.S. deficit for the month of $58.9 billion. But their anger is inappropriate.
Trade numbers like these more an indication of Americans’ demand for the goods that China makes than of an undervaluation of the yuan, the latter being Paulson and the U.S. government’s primary bugbear when it comes to China.
But let’s assume for a moment that the yuan is maybe 50% undervalued, and that tomorrow, its value was to suddenly be adjusted upwards by that dramatic proportion. China would still be the cheapest place for U.S. firms to source virtually all the goods they currently import from the country.
It is likely that the yuan is somewhat undervalued, and it is also likely that when the Chinese are ready, they will allow it to appreciate. But in doing so, they will be making the way of life that Americans have become accustomed to more expensive to enjoy, without necessarily prompting any major change in the pattern of trade between the two countries.
Of course, the story might be different if the yuan’s undervaluation were to be of the magnitude implied by the World Bank’s 2005 judgement of its value based on purchasing power parity (PPP) estimates for the year 2003, which has the dollar equivalent to 1.8 yuan. However, PPP-based exchange rate estimates can be very misleading, and no reasonable observer would expect the dollar to yuan exchange rate to shoot towards that level if the controls were removed tomorrow.
An exchange rate such as that implied by the World Bank’s estimate might well shift some of the manufacturing currently done in China for the U.S. market back across the Pacific. But it is also unrealistic and isn’t likely to come to pass any time soon, even if the yuan were to become a free floating currency. It shouldn’t be forgotten that since July 2005, the yuan has been free to appreciate by a maximum of 0.3% each day, but market pressure for it to do so has been limited, suggesting that the market has a different view on the currency to the U.S. government.
No discussion of this issue is complete without the point being made that while the yuan may be undervalued, the dollar is overvalued. But you don’t hear the Secretary of the Treasury complaining that the dollar isn’t declining fast enough because the Chinese are manipulating it, although they are.
China’s ongoing purchases of U.S. dollar assets with the proceeds of its trade surplus keep the dollar’s parity with other currencies reasonably secure at present levels.
The abandonment by China of this policy would lead to a substantial devaluation of the dollar. My point is that both currencies need to move.
So what’s the solution? A cautiously timed policy shift by the Chinese to allow the yuan to appreciate while allowing the dollar to fall would benefit both countries in the long run. While change is necessary, excessively rapid change, which could potentially hit growth in China and push the U.S. into recession, won’t do anyone any favours.
To avoid this, the two governments should cooperate and try to come up with a timetable, but with the low level of tact being employed last week by Paulson, that may be difficult.
