Is it time to ding Beijing?

There is a growing drumbeat to do something about China’s undervalued currency. In November, Paul Krugman urged the Obama Administration to take the situation seriously. As the financial crisis abates, he wrote, trade imbalances would blossom again.

So picture this: month after month of headlines juxtaposing soaring U.S. trade deficits and Chinese trade surpluses with the suffering of unemployed American workers. If I were the Chinese government, I’d be really worried about that prospect.

In the Financial Times in December, a retired University of Chicago economics professor called for a 10 percent tariff on all U.S. imports from China. Last week, a group of 15 Republican and Democratic senators demanded the Commerce Department to treat China’s currency policy as a subsidy. In just over a month, the Treasury will need to state yet again whether it considers China a currency manipulator.

So what is to be done? There is a very strong case that China’s currency is undervalued. The most telling indicator is that China’s foreign exchange reserves have hit $2.4 trillion and are growing at a rate of roughly $400 billion per year. There is also a strong, but more subtle, argument that it would be in China’s own interest to revalue its currency. But the Chinese leadership has frozen the RMB against the dollar since the middle of 2008.

The question, then, is what policy options are on the table. A menu:

1. Quiet, patient diplomacy. This is the default and is easily the least satisfying to members of Congress. In this approach, the administration works with like-minded countries around the world to apply behind-the-scenes pressure on the Chinese to revalue.

This characterized much of the Bush administration currency diplomacy, which resulted in a substantial appreciation of the RMB from 2005 to 2008. The approach wasn’t domestically popular at the time and is likely to encounter new hurdles now (the Chinese are distinctly less interested in receiving financial advice in the wake of the crisis). 

2. Naming China a currency manipulator. There is an appeal to this. First, it’s honest. By any conventional definition of the word ‘manipulate’, that’s what China is doing. Second, it is a way of venting frustration. The question is whether it will make the Chinese act more quickly.  I suspect the opposite; this will slow the Chinese down. There is already speculation that the Chinese will resume appreciating their currency later this year, as concerns about an export downturn give way to concerns about inflation. However, the Chinese do not want to be seen as succumbing to U.S. ultimata. This is a policy that would make us feel better, but likely be counterproductive. 

3. Sticks and stones. If name-calling doesn’t move the Chinese, what about threats of tariff retaliation? When analysts oppose naming China as a manipulator, it is often because they think this sort of action will follow. This would make it even less likely the Chinese would move, since they could not just let a suitable period of time pass to save face. It would also saddle Americans with the costs of protection and seriously exacerbate existing tensions in Sino-U.S. relations. 

4. A WTO challenge. Using the World Trade Organization as the fulcrum to lever Chinese action is more likely to break the WTO than it is to move the Chinese. One might argue that Chinese exchange rate policy contravenes the spirit of WTO rules, but that has not been the traditional interpretation. Even if the WTO adopts an expansive interpretation – a practice the United States has condemned in the past – it is unlikely this would prompt the Chinese to budge.

5. A multilateral framework. What if the major nations of the world got together to condemn China’s approach to exchange rates? There are a few problems with this. First, the Obama Administration has worked hard to ensure that China has a seat as one of the major nations. In consensus diplomacy, that gives them veto power. Beyond that, it’s hard to give teeth to something like this. The IMF has been authorized to name and shame on imbalances for years and has already criticized China’s currency policy. The Chinese are about as troubled as the United States is when the IMF calls U.S. budget deficits unsustainable. The problem is exacerbated in the case of China because they’re the lender; the IMF has leverage when countries come with hat in hand, not when they come with bulging wallets. 

The fundamental problem is that the Chinese are more scared of the potential pain of currency appreciation than they are of anything the West might realistically throw at them. China recently conducted a "stress test" to look at the possible effects of a currency appreciation. Reuters reports:

According to the initial results of the tests, which focussed on textile, garment, shoe and toy exporters, every percentage point of yuan appreciation would erode one percentage point of their profit margin. This would be a serious blow to profitability since their net profit margin is often only 3 to 5 percent, the newspaper said.

China is afraid of an army of unemployed workers marching around Guangdong sending each other text messages about how unhappy they are. This looks like an existential threat.

In any case, it is a threat China will be compelled to address sooner rather than later. If for no other reason, the Chinese are piling up IOUs from borrowers whose credit looks increasingly shaky and they are making their domestic adjustment problem steadily worse. 

From a U.S. perspective, as unappealing as the patient diplomacy option may be, it may be preferable to all the others. The advantage of letting the Chinese solve their own problem is that it frees U.S. diplomats to ask other things of them. These other things, like cutting directed credit to favored industries, or an understanding on subsidies or government procurement, would help American firms and might actually be achievable.