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Unpegged?

What China's new "floating" currency really means.

12:00 AM, Jul 26, 2005 • By IRWIN M. STELZER
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"THE LONGEST JOURNEY begins with the first step," goes an old Chinese proverb. In the unlikely event that the Chinese authorities' decision to allow the country's currency to appreciate slightly against the dollar is indeed the first step on a long journey to a floating exchange rate, it is only "a baby step," according to the most prominent critic of China's trade policy, New York Senator Chuck Schumer.

True. But even so it accomplished its immediate political objective, cooling some of the anti-China, protectionist sentiment that has been building in Congress as a result of America's massive trade deficit with China, the attempt of CNOOC to take over Chevron, and the release of documents in which the Chinese lay out plans to use economic weapons to weaken America militarily. Add in a Pentagon report documenting the growing military might of China, and the expansion of its geographic reach by purchasing refueling planes, increasing its arsenal of mobile ballistic missiles, and building space-surveillance systems, and you have a heated political atmosphere that the Chinese find worrying.

Both the White House and Beijing have been eager to calm the waters in advance of next week's visit of Deputy Secretary of State Robert Zoellick to Beijing for wide-ranging talks on trade, human rights, and other issues. Which is why the White House went more than a little overboard when describing China's still tightly-managed currency system as "a more flexible market-based currency system," which it clearly is not.

The immediate economic consequences are less significant than the political effects. The 2.1 percent increase in the value of the renminbi can't possibly materially reduce America's trade deficit. That would take a revaluation of somewhere between 10 percent and 40 percent, according to the experts who claim to know these things.

But in addition to the immediate revaluation, the Chinese say they will allow their currency to fluctuate by what appears to be 0.3 percent per day, against a basket of currencies, rather than solely with relation to the dollar. That policy theoretically could result in a substantial cumulative upward revaluation, and begin to whittle away at China's trade surplus.

But the Chinese are unlikely to tolerate such a rapid revaluation, if indeed they plan to take any further steps on the road to a floating currency. Faced with more upward pressure than they care to bear, the authorities can always manage daily trading to prevent the renminbi from appreciating by as much as 0.3 percent, and they can change the mix of the currencies contained within the basket being used as measuring rod. Following the example of Singapore, generally regarded as a successful manager of the value of its currency, the Chinese are refusing to reveal just which currencies will be in the basket, or in what amounts. Experts are guessing that the dollar will make up about 80 percent of the basket, which would mean that the renminbi remains more than loosely tied to the greenback, but not as tightly tied as in the past.

For the Chinese, the advantage of unpegging is that it will be a bit cheaper to buy the dollars needed to pay for imports of oil, copper, and other commodities that are priced in dollars on world markets. But a more expensive renminbi--if indeed the 2.1 percent revaluation is only the first in a series of upward moves--would slow export growth. That is a real worry for the regime, for it is export growth that has enabled their economy to grow at a 9.5 percent rate and create jobs for the tens of millions of Chinese who are moving from farms to cities. The rapid economic growth has also created a middle class that has been content to leave political power in the hands of a Communist elite in return for an ever-rising material standard of living. If growth slows too much, unemployment might rise, workers might become rebellious, and the middle class might seek a share of political power. That is the regime's nightmare, and its reason for clinging to an overvalued currency.

For America, some of the results of devaluation of the dollar are in the "be careful what you wish for" category. The dollar will buy less, forcing Wal-Mart and other major importers to pay more for the goods they now sell at inflation-fighting prices. Not immediately, since China's manufacturers can probably absorb a 2.1 percent revaluation by cutting margins, rather than by raising export prices. But if the renminbi rises further, prices of many goods in America and other importing countries will have to rise.

So, too, will U.S. interest rates. Chinese purchases of U.S. treasuries have helped to keep interest rates down. With fewer dollars to spend, the Chinese might ease up on those purchases. That would add to the upward pressure that Alan Greenspan, rapid growth, and a tightening labor market are already putting on interest rates, which might burst housing bubbles from Miami to Las Vegas.

Not all the news is bad for the United States. Wal-Mart and its customers might suffer, but Boeing airplanes will be cheaper in China, and firms such as MacDonald's, Tiffany, and 3M, which have substantial earnings in the Chinese currency, will get more dollars for those renminbi when they convert those earnings into the U.S. currency.

But the politicians who have been arguing that a revalued renminbi will markedly affect the trade deficit, and stanch the movement of jobs from developed countries to China, just don't know how to do their sums. It is China's overwhelming comparative advantage in labor costs that has enabled it to displace American products in many sectors, from apparel to shoes to electronic products and, soon, autos. No conceivable change in exchange rates can restore American competitiveness in those industries. Fortunately, superior American technology, the flexibility of its work force, and its labor markets, and the robustness of domestic demand are offsets, contributing to job-creating economic growth.

Irwin M. Stelzer is director of economic policy studies at the Hudson Institute, a columnist for the Sunday Times (London), a contributing editor to The Weekly Standard, and a contributing writer to The Daily Standard.