A lot has been said recently about the manner in which China manipulates it's currency, the Yuan. But China wants to hear none of it. In his annual press conference, Mr. Wen Jiabao, China's Prime Minister said that he was "a staunch supporter of free trade" and denied that the Yuan was undervalued. (The Economist, March 18, 2010)
Such denials are reflective of what the world is dealing with. An issue, which should have unified the world against China has, over time, become one which has divided it between Free Trade Proponents and "Protectionists". And amazingly, China is in the Free Market camp.
Ever since Paul Krugman proposed the controversial 25% levy on Chinese Imports into the US, eminent economists like Donald Boudreaux, Greg Mankiw and most recently, Stephen Roach have launched vicious attacks against him labeling him a protectionist who would not only stop world trade, but probably cause World War III.
But before we decide where virtue lies, lets examine the arguments.
Free Trade relies on free markets to be effective. By intervening in its currency market, China has demolished the very foundation of free trade. If Mr. Jiabao is a staunch supporter of free trade, as he professes, the Chinese government should let the currency float and allow a free market to determine its value. In other words, China needs to act like it supports free trade, not just say it. Also, the self appointed guardians of free trade need to examine the logic of supporting government intervention in the currency market while espousing free trade.
If the Yuan were to float, it would appreciate against the US Dollar and all other free float currencies because of the trade surplus that China enjoys. This appreciation would make manufacturers in other countries more competitive and reduce China's trade surplus. In other words, the markets would restore equilibrium and free trade would continue unhindered. This equilibrium is unattainable if China intervenes to decide the price of its currency.
China's currency intervention is the most blatant form of "market protectionism" that has existed and needs to be recognized as such. It benefits China at the cost of it's trading partners and leads to a transfer of wealth from the importing nation to China. But does China need a weak currency? Or does it just desire one.
With its trade surplus, China benefits tremendously from a weak currency. Since it exports more than it imports, a weak currency makes it richer by increasing the value of its exports more than it loses due to increased value of imports. The magnitude of the trade surplus implies that China doesn't need a weak Yuan to compete in the world, but its stance on the currency proves clearly that it desires one. What China gains from a weak Yuan is clearly understood, but in the absence of need, the only explanation for its obstinacy is Greed.
As one of the first proponents of "Competitive Devaluation", China used the currency market to gain a competitive advantage against its peers. Over time, with command policies supporting exports, China established itself in the major markets of the world and then proceeded to compete effectively with domestic manufacturers. The dis-inflationary impact of Chinese imports allowed the US and other importing nations to follow expansionist monetary policies, which created an impression of increasing wealth. However, asset bubbles, supported by a misguided de-regulation of market intermediaries, resulted in a disastrous crisis. A detailed discussion of this is available in an earlier note, China's Currency Policy, The Financial Crisis and the Future of Financial Reform.
But the financial crisis is not the only problem that China contributed to. By keeping the Yuan weak, China effectively ensured that every country competing with it would need to do the same with their currencies. India was, and continues to be, one of them. Except that in India's case, the trade balance is unfavorable and currency weakness actually costs India more on its imports than it's benefit to exports. In essence, currency manipulation by China enriches itself but impoverishes India.
For India, the impact of Chinese currency manipulation along with inherently faulty monetary policy has led to at least one economic crisis. If the Yuan were to appreciate vis-a-vis free currencies, it would result in an environment where most of the past wrongs can be corrected, at least prospectively. More details can be found in an earlier note, Inflation and the RBI. Whether the RBI will have the wisdom to take that opportunity is a question that can only be answered then.
China's greed has sucked wealth from its trading partners and its competitors. The financial crisis of 2008 has called many practices into question and presents an opportunity for the world to unite against China and ask it to play by the rules.
If it's free trade that it wants, it has to respond with free markets.