Thursday, December 17, 2009

The Undervalued Yuan: And Then There Was Silence

In the early part of the decade, it was a routine occurrence for both U.S. administration officials and politicians in Congress to criticize China's longstanding practice of keeping its currency undervalued by way of pegging it to the dollar. In July 2005, China officially de-linked the yuan from the dollar and let it appreciate by about 20% in the next three years to about 6.83 from approximately 8.3 previously. Still, since July 2008, the yuan has, for all intents and purposes, been tied to the dollar again and remained steady around 6.83. As the dollar has lost approximately 10% of its value on a trade-weighted basis since early March of this year, the yuan has also loyally followed the dollar in its slide.

Still, these days, no loud voices are raised among U.S. officials about the overt manipulation of the currency of a country that continues to run a massive trade surplus. In fact, Congress seems to have decidedly backtracked from its drive of a few years ago to put pressure on the Administration to brand China as a currency manipulator. Instead, it appears that it is increasingly the Europeans that are now taking the lead in putting pressure on China to let the yuan appreciate in accordance with its strong underlying fundamentals.

In a trip to Beijing earlier this month, a group of senior EU officials, which included the ECB President, made strongly the case to the Chinese leadership that it is beneficial for both China and the rest of the global economy to let the yuan strengthen. That was the second time in the last two years that EU officials have tried, publicly- and, presumably, in private as well- to exert pressure on China's top leadership to allow for a more realistic realignment of the yuan vis-a-vis other major currencies.

The euro area's concern over the strengthening of its own currency against the U.S. dollar this year has been frequently, and unmistakably, communicated by the ECB President in the last couple of months, as it has been identified as a headwind for the region's fledgling economic recovery. The fact that the euro is at the same time strengthening by a proportionate amount against the yuan as well, obviously compounds those concerns.

The issue for the euro zone's uneasiness over the undervalued yuan in this phase of the cycle is probably less driven by the more narrow issue of the loss of price competitiveness of its exports to China itself, as its trade volume with that country represents only a modest percentage of the region's total exports. Moreover, the euro area's combined export sector is only about 15% of the total GDP of the 16 countries involved, which suggests that, inasmuch as it would certainly be beneficial for the euro area's tenuous recovery to get the most contribution from every possible component of its GDP, exports will probably not be the defining force for the prospects of that recovery.

The true reasons for Europe's anxiety over the strengthening of the euro against both the dollar and the yuan are related to concerns that a) a period of prolonged strength of the first may undermine the long-term competitiveness of the euro-zone's export-oriented manufacturing sector, which represents close to 20% of its total output, and, b) it may hurt somewhat disproportionately the prospects of Germany's economic recovery in particular, given that country's heavy reliance on exports (accounting for close to half of its GDP, including exports to other euro-zone countries). Germany is of course the pivotal economy for the entire euro area.

In comparing the silence of the U.S. recently toward the artificially undervalued yuan, one cannot avoid thinking that the growing dependence on the Chinese as a major investor in U.S. Treasury securities in an environment of skyrocketing budget deficits has been a factor in taming such voices of protest. This willingness to cultivate a close relationship with a reliable creditor-nation was evident earlier in the year when China's leaders requested assurances from the U.S. President that the country's debt will not be downgraded in view of the massive new issuance of securities; not too long afterwards, Obama did oblige, offering such reassurances in public.

While it is true that the sheer size of China's foreign official reserves also leave that country with few good alternatives to the U.S. Treasury market (which offers a unique degree of liquidity and depth that are of critical importance to any major investor on such scale), it is also true that it would be a particularly destabilizing development that could roil global investors and the U.S. Treasury securities market specifically, to see the two countries relations becoming strained in public over any overt criticism of China's currency manipulation practices.

It is undoubtedly that same need to sustain a seemingly cooperative and fairly harmonious relationship with China on the economic front that has also led the U.S. in recent years scale back dramatically, to the point of non-existence, its previous repeated criticism of that country's human rights record. Not much is heard these days about that either and it is not because of any signficant improvement of that record in the last few years..

At the same time, the Europeans, that are not particularly prone to grandstanding on human rights rhetoric around the world (preferring, instead, to adopt more pragmatic positions and solutions) and are also free of any dependence on China's debt financing prowess, now seem to be the only ones with room to continue pressuring the Chinese on the thorny issue of the undervalued yuan.

Anthony Karydakis

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