October 17, 2008    Volume 15, No. 18

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IMF Ministers Meeting In Washington Fails To Address Undervalued Chinese Currency

By Ernest Preeg, Manufacturers Alliance/MAPI

Finance ministers at the annual International Monetary Fund (IMF) meeting this past weekend understandably devoted almost all of their time to the banking crisis, but one casualty was that no attention was given to the misaligned currency problem, and the greatly undervalued Chinese yuan in particular.

This is unfortunate.

The yuan is even more undervalued in 2008 than it was in 2007, and the resulting very large increase in the Chinese trade surplus in manufactures this year is having an adverse impact on the U.S. and European economies now facing low growth or recession.

The overall Chinese trade surplus declined by 3 percent from January through September this year compared with 2007, but this was the result of a more than doubling of the oil import price. The surplus in manufactures, more directly linked to the currency misalignment, in contrast, increased by 31 percent through August, and is on track to rise from $444 billion in 2007 to $580 billion in 2008.

The sharp rise in the surplus for manufactures will become more apparent in the remaining months of the year, when oil prices will be close to the $90 per barrel level in 2007. In August, the total surplus was up by $4 billion compared with 2007, including a $15 billion larger surplus for manufactures, and in September the total surplus rose by $5 billion. The sectoral figures for September are not yet out. October through December should show much larger total surpluses dominated by manufactures.

China now talks of curtailing the appreciation of its currency to protect export-oriented manufacturing jobs. But a $130-billion larger surplus in manufactures this year means a couple of million more manufacturing jobs in China, at the expense of jobs in the United States, Europe and elsewhere. The surplus with the EU has risen very rapidly because of the strong euro and is now almost as large as the surplus with the United States. Moreover, as the United States, Europe and others suffer from low growth or recession, the mercantilist impact of the undervalued yuan on their manufacturing sectors will arouse political as well as economic protest.

The adverse effect is not limited to manufacturing jobs abroad, but also impacts on the domestic Chinese economy. In order to maintain its undervalued currency, the Chinese central bank purchases huge amounts of foreign exchange, up from $430 billion in 2007 to a projected $600 billion in 2008. These purchases are then "sterilized" to avoid inflation by requiring banks to hold a corresponding increase of government securities, which means less bank credit at higher cost for the private sector. The result is less growth in domestic demand, which is supposed to be the offset for a reduced external surplus.

These are the basic facts. The benchmarks for Chinese currency misalignment are large-scale central bank purchases, at $600 billion this year, and the current account surplus, at 11 percent of gross domestic product in 2007. Both are far beyond precedent for a major trading nation, and the misalignment is even larger this year than last.

In June, the IMF touted its new "landmark framework" for exchange rate surveillance "to enable a more focused policy dialogue." The above figures for China should have focused the finance ministers' minds and led to action at the recent meeting, but they did not. Only one out of 16 paragraphs of the report of the IMF Executive Board Reviews of the Fund's Surveillance dealt with exchange rates, and it simply called for further efforts to ensure that these assessments are "candid, evenhanded, and fully integrated." The communiqués of the Group of 20 and the IMF International Financial Committee made scant reference to exchange rates while the term "exchange rate misalignment" was nowhere to be found.

This leaves the whole currency misalignment issue, and the undervalued Chinese yuan, for next year. In this context, the U.S. Secretary of the Treasury is required to report to the Senate Banking Committee twice each year whether any nation is manipulating its currency to gain an unfair competitive advantage. In recent years, the answer has consistently been no for China. It will thus be an early defining moment for the new Treasury secretary when he makes his first report in April.

-- Ernest Preeg is Senior Fellow in Trade and Productivity at the Manufacturers Alliance/MAPI and author of "India and China: An Advanced Technology Race and How the United States Should Respond" (MAPI and CSIS, 2008).

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