China's currency has been pegged to the dollar for about 10 years. Now that the dollar has fallen in value against both the euro and yen, many national competitors claim that China has been given an unfair advantage in world trade. As the dollar has declined so has the Chinese currency. Chinese goods are even cheaper than before, hurting competitors' domestic production and possibly contributing to job losses. U.S. Treasury Secretary John Snow, during his visit to Asia last week, urged Chinese officials to ease the peg without success.

A little history
The renminbi (RMB), which literally means people's currency, is the official currency of the People's Republic of China (PRC). It is issued by People's Bank of China, the monetary authority of mainland China. (Hong Kong continues to maintain its own currency board.) The People's Bank of China (or PBOC) was established on December 1, 1948. The renminbi (it is also referred to as the yuan) was first issued shortly before the takeover of the mainland by the Communists in 1949. One of the new government's first tasks was to end the hyperinflation that was plaguing China at that time. During the planned economy era, the RMB's value was set unrealistically against western currencies and severe currency exchange rules were put in place. But when the Chinese economy opened in 1978, a dual track currency system was instituted - the renminbi was usable only domestically while foreigners were forced to use foreign exchange certificates. The unrealistic levels at which exchange rates were pegged led to a strong black market in currency transactions.

In the late 1980's and early 1990's, the PRC worked to make the RMB more convertible. The exchange rate was brought to more realistic levels and the dual track currency system was abolished. The ultimate goal was to make the RMB fully convertible although that goal was put aside due to the Asian financial crisis, which began in 1997. The currency is convertible on current accounts but not capital accounts. Since 1994, the currency has been pegged against the value of the United States dollar (currently Rmb8.276 to 8.280 to the dollar). The policy was praised during the Asian financial crisis and credited with preventing a round of competitive devaluations. The peg also has enabled the currency to track the dollar's 8 percent decline against a basket of six major currencies the past year. That means Chinese exports to most countries are cheaper than exports from other Asian countries in the Pacific Rim.

Current events
The peg has become controversial. The lower value of the renminbi has led to calls from Japan and the United States to raise the value the RMB in order to encourage Chinese imports and decrease exports. The Chinese government has resisted this pressure. They are concerned that an increased currency value would adversely affect employment and would expose domestic banks to currency risks that they are not prepared to handle.

Within the United States, the issue is controversial with companies lining up on both sides of the argument. Many manufacturers of products such as textiles want to see a higher valued RMB. But other companies such as aerospace companies who depend on the Chinese import market or computer manufacturers who depend on Chinese factories for supply are against a higher RMB. The reality is more complicated than many would care to admit. Chinese exports to the U.S. are often produced in low-cost Chinese factories owned by U.S. companies. There is also evidence that China is merely replacing other Asian exporters as the point of final assembly for products sent to the U.S.

American consumers benefit from cheap imports - but that inflates the trade deficit (and stirs up currency traders who look with increasing displeasure at the burgeoning trade deficit). China's exports are still largely low technology goods, rather than the higher technology goods made by the more advanced economies. But complaints are unlikely to go away. Chinese policymakers, however, have more pressing things to worry about than the effects on others of a cheap RMB. For them, a more critical question is how to stop China's domestic economy from overheating without stepping on the brakes too hard and cooling it too quickly.

John Snow's strong-arm tactics over the exchange rate most recently occurred at last week's 21-nation Asia Pacific Economic Cooperation (APEC) meeting. The U.S. efforts failed to get support from its Asia/Pacific partners in its attempt to push for currency revaluations in the region. Rather, the nations rallied behind China and Japan, which have been holding down the value of their currencies to promote exports. But such pressures are encouraging inflows of hot money betting that the RMB will soon be revalued. China said it might consider scrapping the peg in favor of a link to the currencies of its major trade partners, a concession to Snow who is aiming to correct a trade imbalance and mounting job losses in the U.S. A central bank governor in Beijing said that a tie to more than one currency "can be discussed" but no timetable was given.

Because China's central bank (PBOC) is the sole ultimate buyer of foreign currency, it absorbs all such inflows by exchanging them for renminbi. Analysts estimate that these purchases account for about $25 billion of the country's foreign exchange reserves, which reached a record $356 billion in July. A booming money supply can indicate that higher inflation is on the way. That may seem odd in China, which spent much of last year struggling against deflation and where the consumer price inflation rate is still only 0.5 percent. Now problems created by roaring asset prices and a further increase in China's already enormous bad-debt problems are more likely. In China's financial system, according to the Institute for International Economics, 31.4 percent of loans - equivalent to 44.6 percent of GDP - were non-performing at the end of 2002.

How would a stronger currency benefit China?
A stronger currency would offer China three advantages.

• Most important in the short run would be a stemming of rampant money supply growth that originates in China's external surplus. Contributing to its surplus are foreign direct investment inflows, the return of local capital that had been parked offshore and of course their trade surplus. Resultant credit growth threatens to create real estate and other bubbles.
• A stronger currency would enhance export values and the real wages of China's workers, who would benefit from lower import prices. The main losers would be the foreign companies using China as their source and who now account for more than 50 percent of China's exports. Their profits would fall. But given China's competitiveness, losses would be insufficient to persuade foreign companies from moving elsewhere.
• A stronger currency would take the edge off the growing resentment of many developing countries that are fearful of seeing their own nascent industries swamped by Chinese goods.

China can legitimately claim that its gigantic trade surplus with the United States is largely offset by its deficits with Taiwan, Korea, Japan and Southeast Asia. It is often just the assembler of more sophisticated products made in these countries. Growth in domestic demand in China is also feeding East Asian export growth. The weaker RMB makes Chinese goods cheaper abroad, increasing export demand, which accounts for about a third of gross domestic product. The peg also has helped to attract $308 billion in foreign direct investment from manufacturers as diverse as Bridgestone Corp., the world's biggest tire maker, and Infineon Technologies AG, Europe's second largest semiconductor maker.

China has every reason to move slowly. The government says it needs to expand at a 7 percent rate annually in order to generate enough jobs for the 20 million people who enter the labor force in search of work every year. A stronger currency could cause economic growth to slow in China, damping demand for everything from cars and computers to insurance.

The United States' biggest bilateral trade deficit is with China. Asia as a whole accounts for about half of the total deficit. If currencies cling to the dollar, then others such as the euro will have to rise disproportionately if the U.S. deficit is to be trimmed. The Chinese renminbi and the Malaysian ringgit are pegged to the dollar and protected by capital controls. The Hong Kong dollar is also tied to the dollar through a currency board. Officially, other Asian currencies float, but central banks have been intervening intensively to hold down their currencies as the dollar has weakened. Asian governments worry that appreciating currencies might hurt their exports. Yet many of their currencies are very competitive. As the dollar slides, their trade-weighted values against a basket of currencies falls. According to The Economist's Big Mac index, China has the most undervalued currency in the world. Others using more sophisticated methods say that the RMB is now more than 20 percent undervalued against the dollar.

In a free market, China's currency would rise. But demands from foreigners are likely to fall on deaf ears. The Chinese government is worried about rising unemployment as jobs are lost in unprofitable state companies and as deflation remains an issue. Moreover, until banks are reformed and non-performing loans tackled, it would be dangerous to liberalize the capital account. It would be safer to repeg the currency at a higher rate. But most economists reckon that, at best, the currency's band will be widened slightly over the next year - without allowing room for any significant appreciation. And, so long as the renminbi is pegged to the dollar, other Asian countries will have a big reason to resist appreciation too.

Bottom line
Recent rhetoric on both sides has created friction. It makes no more sense to blame China for American trade and employment problems than it does to praise China for buying U.S. bonds or keeping a stable currency in a volatile world. Revaluations are not a cure-all. But they would be good for an increasingly interdependent East Asia, spurring the local consumption needed to offset the inevitable leveling out of U.S. import demand. China, above all, needs consumption growth to absorb the output of its surge in fixed asset investment and to find better use for some of its $350 billion in reserves. But U.S. pressure on China may be limited because the United States needs China's help in resolving tensions with North Korea. Another reason is that China and other Asian countries hold their reserves largely in American government securities. If Asians lose their appetite for dollar assets, the dollar would fall faster and American bond yields would rise.

Anne D. Picker, International Economist, Econoday