Eye on China: One currency, two views

The single greatest issue facing anybody trading or investing in China now is whether the decade-long link between the US dollar and the yuan will be dismantled.

The peg is set at 8.28 yuan to the greenback, a value the US believes understates the yuan's true strength by at least 20 per cent. As a result, the peg has become the focus for US politicians wishing to protect the jobs of their constituents and to reduce the United States' US$700 billion trade deficit. It has also become a test of how China's leaders, President Hu Jintao and Premier Wen Jiabo, can resist US pressure.

The US knows that if the yuan is made to strengthen, more US dollars will be needed to acquire Chinese goods. More expensive Chinese goods should mean reduced demand, thereby trimming the US deficit with China (25 per cent of the total US deficit comes from China), giving local goods a better chance.

However, it is possible to accuse the US of bad faith. Some argue that a fairer and less confrontational way to reduce the trade deficit would be by signalling to US citizens - through much higher interest rates - to consume fewer foreign goods.

As the huge capital flows to the US show, much of that consumption is financed by foreign debt. So reducing consumption of imports would lower US debt as well as the trade deficit, and lead to a stronger US dollar.

There is only one problem with this argument, but is a big one. It would offend the US consumer - politically a difficult option.

It is also possible to accuse the Chinese of playing currency games. The US does not believe that China's export success comes from some special business genius. Rather, the US believes the trade deficit and foreign exchange mountain indicate a deliberately undervalued currency.

It could be right.

When currencies float against each other, the currency of a successful exporting nation eventually rises in value. That is because as exporters switch their US dollar earnings into their local currency, the increased demand makes that currency more expensive. That means more expensive exports, which reduces demand and eventually smooths out the trade deficit.

Under a pegged system that doesn't happen. The Chinese currency is simply not permitted to trade at a value other than 8.28 to the greenback. Therefore, Chinese exporters continue to enjoy the benefits of a cheap currency and cheap exports.

US economists also point out that the real purchasing power of the yuan has strengthened by about 20 per cent in the past few years. Yet the nominal exchange rate has remained the same, indicating an undervaluation of the currency.

Note the potential for conflict: the US government would like to shrink the trade deficit by making the yuan stronger while, conversely, the Chinese want a strong US dollar.

They accomplish this by investing their huge export earnings in US dollar-denominated debt. The enormous demand for the US dollar thus generated by China bolsters it against the yuan and, ironically, finances the US trade deficit.

Were the debate to remain in the economic sphere, Chinese concerns would be limited.

But, of course, there is a political dimension and the precedents make China profoundly uneasy.

Take the experience of Indonesia's former leader Suharto. Many Chinese believe the Indonesian rupiah, which was also pegged to the US dollar, was forced off the peg by the intervention of the International Monetary Fund, to bring about the economic collapse of the country and, hence, regime change. The plan, if indeed there was one, worked beautifully: widespread resentment in the wake of the bank failures and capital flight triggered by the devaluation of the rupiah forced Suharto out of power in 1998.

The Chinese will also have seen the effect currency devaluation had on Japan. In the 1980s, the US was facing many of the problems it faces now, including spiralling trade and budget deficits.

In 1986, the US convened the world's No 2 and No 3 economies, Japan and Germany, and told them to find ways to shrink the US trade deficit ... or else.

The result was the 1986 Plaza Accord, at which Japan (Germany demonstrated more spine) agreed to help reduce the US deficit by boosting domestic consumption. Japan slashed interest rates and printed money at twice the growth rate of GDP, thereby unleashing a terrific bubble. As is well known, that bubble detonated in 1990 causing a crash that is still reverberating throughout the Japanese economy.

If that's the way the US treated its most loyal east Asian ally, the Chinese have every reason to be concerned about how the US will use economic policy against them, a country many Bush hawks view with suspicion. This is one issue that will fester for a while yet.

* The writer remains anonymous to protect his position in China.