China’s currency reforms may make ‘get tough’ promise moot

Presidential candidates of both parties like to score points with voters by promising to get tough with China, but recent evidence suggests that currency reforms quietly adopted by the Asian giant since 2005 have come close to eliminating the biggest trade distortion and bone of contention between the two countries.

U.S. leaders have complained for years that Beijing manipulates the value of its currency against the dollar to ensure low prices for Chinese imports and gain an advantage in trade over higher-priced American products. Partly because of such currency suppression over the years, China has taken over entire markets for consumer goods in the U.S., including Christmas ornaments and cribs, by underpricing competitors, causing the U.S. trade deficit with China to bloat to the largest in history, a record $295.5 billion in 2011.

President Obama, while celebrating recent progress on the currency issue under his administration, frequently says it is not enough and exhibits his political macho by targeting China for high-profile trade enforcement actions involving solar panels, wind turbines and other products.

Republican presidential nominee Mitt Romney has sought to one-up the president by taking the strongest stand of any candidate against China. He vows to crack down on its alleged currency manipulation as one of his first acts in office — a move that Chinese leaders have warned would provoke a monumental trade war between the world’s two largest economies.

Despite the rhetorical bombast, leading financial analysts say considerable progress already has occurred in realigning the currencies. Under pressure from the George W. Bush and Obama administrations, China since 2005 has allowed its currency to gain more than 30 percent in value against the dollar, and analysts say the Chinese yuan now appears to be close to a fair, market-determined value for the first time.

In fact, Moody’s Analytics declared recently that the yuan’s rise may have gone too far and it may be slightly overvalued with respect to the dollar. Wall Street powerhouse Morgan Stanley says the realignment of currencies has gone so far that it is now causing considerable pain for Chinese exporters and will force them to start raising their prices on Chinese imports in a major way. That would be an important development that not only would make perennially cheap Chinese products a thing of the past in the U.S., but could significantly change the economic and political relationship between the two economic superpowers.

“When it comes to economic relations with China, U.S. political leaders are responding to the problems of yesterday rather than preparing for tomorrow,” said Samuel Sherraden, an analyst at the New America Foundation, contending that the currency fight is a thing of the past.

“Lawmakers in both parties — from Republican Mitt Romney to leading Democrats on Capitol Hill — continue to criticize China for its currency manipulation” but seem to be missing the fact that the currency is now fairly valued while other major economic problems have emerged in China that could have “dangerous spillover effects for the U.S.,” he said.

Specifically, China is experiencing a major economic slowdown this year — a principal reason its currency stopped appreciating against the dollar. Mr. Sherraden said the slowdown poses a substantial threat to U.S. growth because China had been America’s fastest-growing export market. Recent economic reports show a big pullback in U.S. manufacturing this spring, which appears to be reflecting a tanking of U.S. exports to China and the European Union.

Moreover, Mr. Sherraden said, there are signs that China’s slowdown could turn into a full-scale economic rout that would be devastating to the already stagnant U.S. economy. All the rhetoric focused on China’s currency just inflames nationalistic passions in Beijing, he said, and may be preventing China’s leaders from attending to the more pressing economic matters at home.

Currency fairly valued

A growing school of financial analysts agree that China’s currency is no longer undervalued and that economic growth is the bigger problem facing both countries.

“The market thinks the yuan is near fair value,” said Alaistair Chan, author of the Moody’s analysis. Moody’s and a few other forecasters estimate that the yuan actually has gained more than the 30 percent in nominal appreciation against the dollar seen since 2005. When the faster rate of inflation and wage growth in China are taken into account, it could be considered as much as 60 percent higher, they estimate.

The sea change in currency rates suggests that the pressure applied by U.S. administrations of both parties since the 1990s has been largely successful. Because of the economic weakness in China this year, global investors are no longer betting on the inexorable rise of the Chinese currency against the dollar, but rather now expect it to start depreciating modestly in value, Mr. Chan said.

The downward pressure on the yuan this year has been so strong that Chinese authorities even had to intervene to prop up its value by selling dollars this spring. That represents a complete reversal for the Chinese, who for more than a decade intervened strenuously to prop up the value of the dollar by selling yuan, to ensure China’s vast export sector remained competitive. China’s massive dollar purchases over the years are what led to its amassing an unprecedented store of dollar reserves worth $3.2 trillion at the end of last year.

Even with the recent intervention by the People’s Bank of China to support the yuan, since February the Chinese currency has lost about 1 percent of its gains against the dollar because of the precipitous slowdown in economic growth there. Analysts estimate China’s annual growth rate has fallen to about 6 percent this year from more than 10 percent last year.

William R. Cline, senior fellow at the Washington-based Peterson Institute for International Economics, says China has been responsive to global demands concerning its exchange rate. He said the yuan’s rise against the dollar and other major currencies from 2005 to 2007 was instrumental in reducing China’s chronic trade surplus with the United States and the rest of the world from 10 percent of economic output in 2007 to only 2.8 percent last year.

Mr. Cline estimates that if China allows the currency to keep appreciating by about 3 percent a year — its pace until this year — that would eliminate the country’s trade surplus by 2017.

Thus, Mr. Cline concludes that the huge trade imbalance between the U.S. and China — which has “widely been seen as the most serious source of global imbalances” and is believed to have contributed to the 2008 financial crisis — appears to be in the process of mending itself, thanks to policies China adopted under pressure from the U.S., Europe and other Group of 20 economic powers.

Consumers unaffected so far

While China is making progress in the face of long-standing demands that it loosen restrictions on its currency, so far not all of the yuan’s rise has been passed through to U.S. consumers. The disconnect may be feeding the impression among politicians and the public that China continues to suppress its currency.

A study by the New York Federal Reserve found that as recently as a year ago, there had been no widespread price increases in Chinese imports despite the significant rise of the yuan. The disconnect appears to be because Chinese exporters have absorbed much of the cost of the currency realignment, keeping their prices low in a bid to retain their share of the lucrative U.S. market and avoid scaring off U.S. customers.

But that may be about to change.

Since June 2010, when China started allowing its currency to rise again after a lull during the recession, Chinese exporters have passed through about two-thirds of the 7.45 percent increase in the yuan against the greenback by raising the prices on Chinese products, according to the Labor Department’s import price index.

The Chinese price increases may be about to accelerate, according to Morgan Stanley. The Wall Street firm is predicting that Chinese exporters will not be able to keep absorbing costs much longer and soon will be forced to start jacking up prices more vigorously.

Profit margins of Chinese exporters have fallen by between 20 percent and 30 percent since 2004, Morgan Stanley estimates, affected both by the falling value of their dollar earnings on exports, and by accelerating wages in Chinese factories that have been rising an average of 14.5 percent a year for the past decade.

The monumental profit squeeze most likely has reached the threshold of pain, said Morgan Stanley analyst Spyros Andreopoulos.

“Sooner or later, Chinese exporters will have to raise their prices to defend margins,” he said, noting that anecdotal evidence suggests that “many Chinese exporters are increasingly doing exactly that.”

The rise in prices eventually will have the effect sought by political leaders — a rebalancing of trade as Chinese exporters become less competitive and U.S. manufacturers become more competitive, he said. But it also will have the not-so-welcome effect of generating a potentially significant rise in inflation as price increases for Chinese goods feed through to the overall level of prices, he said. The inflation pressures would be even greater if China’s price increases lead to me-too price increases by competitors in South Korea, Taiwan and elsewhere, he said.

Inflation threat seen

Since China provides about one-fifth of goods imported into the U.S., the rise in prices — if it is big enough — could touch off worries at the Federal Reserve that the long period of tame inflation in core consumer prices is over, Mr. Andreopoulos said.

The Fed’s St. Louis reserve bank last year signaled the central bank’s potential concerns, concluding that — despite the intent of political leaders to spur U.S. jobs by making U.S. products more competitive — the yuan’s rise is more likely to touch off a round of worrisome import price increases than bring significant job opportunities back to the U.S.

Erin Ennis, vice president of the U.S.-China Business Council, which represents U.S. companies that manufacture products in China, said politicians who expect the currency realignment to result in more U.S. jobs are simply mistaken.

A large share of the goods imported from China are not made by Chinese companies but by affiliates of U.S. companies that have located plants in China to take advantage of lower wages and environmental costs. Japanese and Korean companies for the same reasons also manufacture products in China and export them to the U.S.

It is far from clear that those jobs will return to the U.S. if factories in China close, Ms. Ennis said.

“Much of what we import from China today simply replaces imports from other countries like Japan, Singapore and South Korea, not products we make in the U.S. today,” she said. People who blame China for U.S. job losses are simply “ignoring the realities of global supply chains and modern manufacturing techniques,” she said.