Yuan Shored Up Against Pressure From Washington And Tokyo

The U.S. Treasury has, as has become its custom, again declined to label China a currency manipulator. Its latest semi-annual report to Congress does say the yuan’s effective exchange rate remains “significantly undervalued” against the dollar, though it acknowledges that the Chinese currency has appreciated by 33.8% by that measure since currency reform started in 2005. It again calls for more exchange rate flexibility on Beijing’s part. All pretty much par for the course, and intended for domestic political consumption as much as anything.

More weight is given to its call for stronger policy changes on Beijing’s part to embed rebalancing. The Treasury remains concerned that the lessening of the surplus on the external account isn’t “enduring”. “Without more forceful structural reforms to promote domestic consumption, there is a risk that China’s imbalances will re-emerge as the global economy recovers,” it says. There would be little disagreement from this Bystander that further exchange rate reform is a necessary if far from sufficient condition for rebalancing.

In the meantime, the People’s Bank of China seems to have been intervening in the foreign exchange markets again on a large scale with activity intensifying since the fourth quarter of last year. The reversal in the slowing of foreign exchange reserve accumulation seen in the first three quarters of 2012 points to this.

This may as much as anything be being driven by the weakening of the yen ever since it became clear that Shinzo Abe would become prime minister last November. Though the official line in Tokyo is that the new government and its newly installed governor of the Bank of Japan aren’t targeting exchange rates, a weaker yen is a necessary precursor for the aggressive monetary policy aimed at achieving an domestic inflation target of 2% to work. Washington says it is monitoring the yen closely. With the yuan still closely tied by its 1% band to movements in the dollar, so is Beijing.

Inflating The Yuan’s Value, Not Manipulating It

The U.S. Treasury has danced its way, as is its wont, around designating China as a currency manipulator. In its latest half-yearly report to the U.S. Congress, it says that China’s high inflation means that the yuan’s real (inflation-adjusted) exchange rate with the U.S. dollar has risen by an annualized 10% since Beijing started allowing its currency to rise again against the greenback last June. On a nominal basis the yuan rose 3.7% over that time.

Were the Treasury to declare that Beijing was manipulating its currency, it would trigger retaliatory actions by the Congress, where many believe that it does. That, though, would be a ramping up of Sino-American tensions that neither government would want to deal with, especially in the wake of President Hu Jintao’s state visit to Washington last month that put the relationship on a less overtly confrontational footing.

The Treasury did, however, repeat another of its favorite tunes, that the yuan remains “substantial undervalued” agains the dollar, and that more rapid progress is needed in its revaluation.

China’s real effective exchange rate has appreciated only modestly over the past decade. China’s large increases in productivity in export manufacturing, improvements in transportation and logistics, and China’s accession to the WTO all suggest that the [yuan] should have appreciated more significantly on a real effective basis over this period.

To seek to change that, the Treasury strikes a note of encouragement, rather than chiding:

It is in China’s interest to allow the nominal exchange rate to appreciate more rapidly, both against the dollar and against the currencies of its other major trading partners. If it does not, China will face the risk of more rapid inflation, excessively rapid expansion of domestic credit, and upward pressure on property and equity prices, all of which could threaten future economic growth. By trying to limit the pace of appreciation, China’s exchange rate policy is also working against its broad strategy to strengthen domestic demand. And China’s gradualist approach on the exchange rate also adds to the substantial pressure now being experienced by other emerging economies that run more flexible exchange rate systems and that have already seen substantial exchange rate appreciation.

Beijing’s policymakers know that that to be the case. They are just doing a slow foxtrot with the yuan for domestic social and political reasons, and won’t be rushed into picking up the tempo.