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Considering China’s Currency

Prepared by: Lee Hudson Teslik
June 14, 2007

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The valuation of China’s currency has animated economists for over a decade. After years of pressure from Washington, China floated its currency in 2005, abandoning a strict peg to the U.S. dollar and opting, rather, for an exchange rate pegged to a basket of international currencies. This move created a modicum of wiggle room for the yuan, but U.S. officials still say China grossly misvalues its currency and that this disparity significantly distorts global trade, exacerbating U.S. and European trade deficits. Indeed, in an interview with CFR.org, U.S. Treasury Secretary Henry M. Paulson says the yuan “doesn’t reflect reality” and the need for reform is even greater now than it was in 2005.

Legislators in Washington, meanwhile, demand a stricter approach toward China. On June 13, a bipartisan group of U.S. senators proposed legislation that would require the Treasury Department to work with the U.S. Federal Reserve and other banks to actively intervene (FT) in currency markets when they appear distorted. The same day, the Treasury released its semiannual report on currencies, focusing heavily on China. The report says China’s currency is “severely unbalanced” and calls for prompt action by the Chinese government, but stopped short of accusing China of currency “manipulation,” a term that implies intent to gain an edge in trade.

Whether or not China is actively “manipulating,” the balance sheet shows profound and growing trade disparities with the United States and other industrialized nations. Skewed currency valuations only exacerbate the problem. The trade gap between European Union and China was the focal point of June 12 meetings between EU Trade Commissioner Peter Mandelson and Chinese Commerce Minister Bo Xilai. China’s trade surplus stands at $22.5 billion, up 73 percent (AP) from a year ago. This 2006 Backgrounder looks at the burgeoning U.S. trade deficit and efforts both to control U.S. spending and to increase consumer culture in countries like China that carry substantial trade surpluses.

Still, experts say a move toward equilibrium will take time. Paulson argues that, in the near term, the prudent course for the United States is to push China for greater “flexibility” with the hope that in the “intermediate term” the yuan could be traded on the open market. The overwhelming fear among economists is that any rapid change could jolt markets. These concerns in mind, Morgan Stanley Chief Economist Stephen S. Roach argues in a recent online debate that pressing for quick changes in China’s currency is the “wrong medicine at the wrong point in time.” Roach also encourages the United States to look more pointedly at U.S. economic failings: “There’s a limit to what can be expected from China and a lot more we can ask of ourselves.”

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