China fears exaggerated

Another issue that seems likely to persist through the second half is speculation about a change in China’s currency regime. Some observers portray China’s peg as an important domino, and when it goes, other countries in Asia will also fall to the G7 demand for more flexible currency regimes.

One problem with this theory is several East Asian currencies, such as the South Korean won and to a lesser extent the Taiwanese dollar and Philippine peso, have already shown somewhat greater flexibility.

Last year for example, the South Korean won appreciated 15 percent against the greenback and the Taiwanese dollar rose 7 percent. Through the middle of May this year, the won appreciated another 3 percent, the Taiwanese dollar 1.2 percent, and the Philippine peso 3.5 percent. Many global investors do not appear to be waiting for China to speculate on East Asian currencies or their equity markets.

The risk is that many economists and market observers are placing too much significance in a change in the Chinese currency regime. In the 50s and 60s, the big bugaboo was the Soviet Union, not just because of its nuclear weapons, but because it was the first country to launch a satellite and because of its rapid industrialization. Then in the late 70s and 80s, Japan was supposed to eat our lunch. Now many look over their shoulders and see China rapidly approaching.

The fear of China is likely exaggerated. First consider that China accounts for only 10 percent of U.S. trade. That means a 10-percent appreciation of the Chinese renminbi translates into a 1-percent decline of the dollar on a trade-weighted basis — and that 10 percent seems at least twice the size that many expect.

China is caught in a bind and the publicly applied pressure does not help matters. Economists, officials, and other observers have expressed two distinct demands. The first is for a more flexible currency regime. The second is for currency appreciation. A more flexible regime could entail a wider band for the renminbi which currently is allowed to move by 0.3 percent. A small widening of the band to 5 percent would hardly resolve anything.

The currency would likely move to the strong side of the band, which would then have to be defended by officials. This would require the continued accumulation of reserves (often dollars and Treasuries) and the expansion of the domestic money supply.

A small appreciation would not likely change global capital or trade flows. The way China competes in the world economy is not simply through its currency valuation. Rather, as the Asian Development Bank recently reported, skilled Chinese labor in the manufacturing sector earns roughly 4 percent of prevailing manufacturing wages in the U.S. China has other competitive advantages — state of the art infrastructure in some parts, a docile workforce (no unions in this workers’ paradise), tax incentives for multinationals, and a rapidly growing middle class and domestic market.

A small appreciation of the renminbi would likely prove insufficient to satisfy the protectionists in the U.S. and Europe. Some estimates claim the renminbi is 40- to 50-percent undervalued. Of course, such estimates need to be taken with a grain of salt, as currencies from the developing world are notoriously undervalued on a purchasing power parity basis.

Protectionism is clearly not the answer. Roughly half of Chinese manufacturing exports are produced by multinationals. Nearly a quarter of the U.S. imports from China come from U.S. companies. Wal Mart alone accounts for nearly 10 percent of U.S. imports from China, helping many American consumers stretch the purchasing power of their income, which has hardly kept pace with inflation.

Despite all the lip service paid to the virtues of the market, few officials really advocate allowing the renminbi to float, perhaps because it likely would sink. There would be an unwinding of the speculative trade — the hot money would sell the renminbi and look for the next trade. Multinational corporations would repatriate more of their profits from China if they were allowed to. And of course, the economic elite in China would want to take some part of their wealth offshore, which would also entail selling the renminbi.