China currency syndrome (Tuesday, November 9, 2010)

Undervalued renminbi continues to ail world economies, and China's initial cure isn't strong enough.

It is exceedingly rare that episodes of asset or commodity prices substantially deviating from levels based on fundamentals, such as supply/demand equilibrium, come to an end without wreaking economic havoc.

The Chinese renminbi is widely viewed as pegged at a level that's severely undervalued against the dollar. Many world economies are feeling the ill effects of this, and policymakers are beginning to react. Watching China defy them is worrisome because, as was pointed out in the February column, pegging the exchange rate of the world's two largest economies' currencies produces a global economic imbalance.

In the nearly 10 years since China joined the World Trade Organization, its trade advantage with the United States increased 173 percent from a surplus of $83 billion in 2001 to $227 billion in 2009. Through July 2010, China is already ahead $145 billion and is on track to exceed the 2009 surplus.

If markets were able to function normally, a growing trade deficit would result in a substantial appreciation of the renminbi against the dollar. Chinese exporters would sell the dollars they were paid in order to buy renminbi that could be used to pay for their expenses. Since China has been exporting more goods to the United States than it has imported, the faster growing demand for yuan should have pushed its value up against the dollar.

In 2001 $1 could be exchanged for 8.28 renminbi. Today, the rate is $1 to 6.69 renminbi, appreciating 24 percent over this period. Most of that occurred from July 2005 to September 2008 when China allowed its currency to slowly appreciate against the U.S. dollar.

Appreciation of the renminbi would have slowed the growth of the China-U.S. trade imbalance because Chinese goods would become more expensive in the United States and American goods would become cheaper in China. This most likely would have prevented the frenetic pace of outsourcing of U.S. manufacturing over the last decade.

China believes it has a lot to lose from allowing a sudden appreciation of the renminbi against the dollar. According to the Chinese government, manufacturers there have small profit margins and many would have to shut down if the renminbi appreciated very quickly. There would also be financial losses.

In order to maintain the exchange rate at a fixed level, China could not sell the dollars earned from U.S.-bound exports. Therefore, it invested its dollars in U.S. government bonds. According to the U.S. Treasury, as of July, China owns $847 billion of U.S. Treasury bonds and has been the largest foreign owner of U.S. Treasury securities since 2008. In 2002 China was fifth-largest, owning $182 billion, well behind Japan, which held $637 billion at that time.

However, China could actually gain from an appreciation of the renminbi. China imports a lot of raw materials. Most commodities, such as oil, copper, iron ore, soy and corn, are traded in global markets where prices are quoted in U.S. dollars. Some commodities, oil in particular, are purchased at prices set in the world market, but sold domestically at lower prices. Appreciation of the renminbi against the dollar would lower the cost of those raw materials, which could permit the government to stop subsidizing the cost of raw materials for domestic consumption and allow Chinese products to remain competitively priced for the U.S. market.

Removing the currency peg would also improve trade relations with other large economies such as Brazil. Brazil exports substantial amounts of iron ore, soy and sugar to China, all priced in U.S. dollars.

The Brazilian real has appreciated against the U.S. dollar from 3.8 reals to $1 in 2002 to its current level of 1.7 reals to $1. The real's appreciation is the result of higher economic growth, which is reflected in higher interest rates in Brazil. This appreciation has reduced the value in reals of the country's raw material exports.

The real's appreciation against the dollar combined with the renminbi's peg to the dollar has made Chinese goods cheaper in Brazil. Brazil has significantly increased its imports of goods manufactured in China. Some industries, such as shoe manufacturing, have lost significant market share to shoes made in China, not only in Brazil but also in other countries.

This runs contrary to Brazil's longstanding economic development strategy to grow its manufacturing industries. The situation is worsened by China's investments in raw material production and transportation infrastructure in Brazil. Making matters worse, the capital flowing into Brazil to fund these investments are likely to have caused the real to further appreciate.

It is no surprise that Brazil has increased its use of antidumping tariffs in the last few years on some products made in China.

Other countries are also feeling currency pressures. The Thai and Indian central banks have complained that significant inflows of western funds pursuing growth opportunities in emerging markets are pushing up their currencies and, in India's case, fueling inflation. By default their currencies are also appreciating against the renminbi, which reduces the competitiveness of their exports on the world market.

So far Europe, which unlike the United States runs a trade surplus with China, has not complained as much. However, the euro has appreciated against the renminbi and policymakers there are concerned that the euro is appreciating against the U.S. dollar because of the renminbi's peg. This can negatively impact growth in Europe by making its exports less competitive in the United States.

Given that China is now the world's second-largest economy, according to economic statistics, the renminbi's peg to the dollar is a major source of unsustainable global economic imbalances and the greatest risk factor in the outlook for global trade. Even though China began allowing the renminbi to appreciate against the dollar as of July, this is not happening fast enough to appease countries that are negatively impacted.

It is not too optimistic at this point to expect a globally coordinated effort to help China withdraw the currency peg at a faster rate. Until that actually begins to happen, the risk of a "currency war" with negative implications for world trade continues to increase.