Gerard Jackson
BrookesNews.Com
Thursday 21 August 2003

Writing in the Washington Times Jerry J. Jasinowski, president of the National Association of Manufacturers, argued that China has "a deliberately undervalued currency" so that it can undercut US competitors (Made in China 20 May 2003). This theme of deliberate undervaluation has been picked up by others and used as an excuse to demand that Washington take action against China.

Mr Jasinowski's solution is to impose "market-driven rules that level the playing field and allow U.S. producers to use their own formidable competitive advantages." One of the most important of these rules, according to Mr Jasinowski, would be to end currency manipulation and allow the yuan/exhange rate to be determined by the market.

However, it is not all clear whether China is really guilty as charged. Mr Jasinowski certainly provided no evidence that Beijing was artificially keeping the yuan undervalued. It appears that because China has accumulated $280 billion in foreign exchange reserves this is evidence enough of currency manipulation.

Even if the charge is true, those who make it are assuming that there would be no costs to China in manipulating the exchange rate. On the contrary, currency manipulation can have severe repercussions for those nations who practise it. What critics fail to see is that trade is driven by differences in prices. Although it is true that when a country forces its currency below its market rate this will artificially lower the prices of its goods relative to other currencies, the damaging effect of these price changes will reverberate through the economy.

If China has forced its exchange rate down, meaning it has imposed a maximum price on the yuan, this will open the door to arbitrage. It will now pay Americans to buy yuan which will then be used to buy Chinese goods. These goods will be imported into America and exchanged for dollars which will then be used to buy more yuan, and so on. The effect of this process will be to exert an upward pressure on the Chinese currency.

At the same time it will pay Chinese businesses to offer more goods for dollars, exchange these dollars for undervalued yuan and then use them to buy more goods which are then offered for dollars. This process is very similar to the previous one and also works to bring the yuan into line with its market value.

While foreign trade in the form of arbitrage is exerting pressure on the yuan other forces, insidious in their nature and acting through prices, will be working their way through China's production structure.

Assuming that the yuan could be kept undervalued for a long time the effect would be to make China excessively export oriented. Capital will be attracted into lines of production that are expanding in reaction to the increased demand for exports. What this means is that capital and savings are being misdirected into less valued lines of production to the detriment of the economy. This process raises the cost of capital goods and savings for other lines of production and thus restricts their expansion.

The process does not stop there, however. US companies may be misled by the exchange rates into thinking that it is more profitable to produce for the US market by shifting operations to China, thus adding to the imbalances.

It should be clear that whatever additional dollars are acquired through this process their accumulation will be offset by the costs of misdirecting capital. Once again, there is no such thing as a free lunch.

The preceding analysis leads to the conclusion that the consequent distortion of the production structure must eventually lead to a severe shakeout once the exchange rate is forced back into equilibrium. Export oriented companies will find that they have over invested and liquidations will have to take place, unless the state steps in with massive subsidies. US companies that invested because of the artificial exchange rate will also suffer losses. All in all, a great deal of capital will have been wasted.

Now let us consider the possibility that the problem is one of an overvalued US dollar, meaning that it is the dollar that needs adjusting and not the yuan. The consequences of this for China will be exactly the same as if her government had deliberately undervalued her own currency.

In a world of continuously changing money stocks there is bound to be a great deal of exchange rate disequilibrium. The problem, once again, is government meddling in the market place. Even if Beijing is manipulating the currency it is not doing the Chinese people any favours.

Gerard Jackson is Brookes' Economics Editor