U.S.-China Exchange Rate Thicket

The U.S. and Chinese positions on China’s exchange rate policy have not changed substantially in the run-up to today’s state visit by President Hu Jintao. Washington argues that by maintaining a substantially undervalued exchange rate, China is gaining an unfair competitive advantage that sustains a large trade surplus to the detriment of the United States and many other countries. China’s exchange-rate policy is seen U.S. officials as playing an important part in holding back adjustment of global imbalances and delaying a more balanced and sustainable recovery in the world economy.

While acknowledging that China has allowed greater exchange rate appreciation, especially in the weeks preceding Hu’s visit, the United States argues that much more needs to be done on a sustained basis. Moreover, Washington stresses that faster appreciation in the currency is in China’s best interest. It will help deal with China’s growing inflation problem and will, along with other needed policy changes and economic reforms, facilitate a speedier rebalancing of China’s economy away from heavy dependence on investment and exports toward greater reliance on consumption to drive economic growth.

China, for its part, has established rebalancing of its economy as a policy objective, but it stresses the need for a gradual transition to avoid disruptions in continued rapid economic growth and employment in China. A more rapid-paced rebalancing of China’s economy over the next few years with a substantially faster rate of yuan appreciation is also not seen by the Chinese as necessary. In their view, China did not create the problems that led to the economic and financial crisis and faster appreciation of the yuan will not solve the woes of the advanced economies.

This view holds that the advanced economies need to correct their own policy imbalances, particularly sizable fiscal deficits. In addition, Beijing points to problems created by the role of the U.S. dollar as the world’s primary reserve currency and the recent renewed quantitative easing of U.S. monetary policy. It calls for a diminished reserve-currency role for the dollar as part of a more equitable and resilient international financial system.

While China is right that the reserve-currency role of the dollar allowed the United States to run a persistent fiscal deficit, the harm from this policy primarily fell on the United States; other countries experienced a boost to economic growth. In contrast, China’s exchange-rate policy poses a more serious problem, giving China an unfair competitive advantage and creating distortions in the pattern of trade. This policy also contributed to the severity of the economic and financial crisis as China’s international reserves rose sharply and China poured money into U.S. assets, helping to sustain easy credit conditions in the United States. In addition, concerns now that U.S. quantitative easing will create potential problems with inflation and capital flows for other countries arise not because of China’s exchange rate policy and how that policy compels other countries to limit changes in their exchange rates to try to preserve their competitiveness.

The Obama administration admits that appreciation of the yuan alone will not solve all of the problems of the world economy. In particular, Washington recognizes the need to boost national savings, primarily through consolidation of the fiscal deficit. However, adjustment to imbalances in the United States and other advanced economies will take longer and will be much more difficult without greater flexibility in China’s exchange rate.

But China clings to its current policy of limited, gradual yuan appreciation. This is due, in part, to inertia given the past economic success of its exchange rate policy. Looking ahead, there will also be difficulties in taking decisive policy actions during the period leading up to the March 2013 change in leadership and the reshuffling of positions in the government and communist party hierarchy.

It is difficult to see how the difference in view on the needed speed of exchange rate adjustment between the two countries will be resolved. Coming into this week’s summit, Hu emphasized both countries stand to gain from a sound U.S.-China relationship and that they lose from confrontation. But unless China shows a willingness to permit a more rapid and sustained appreciation of its exchange rate in the period following these meetings, the United States may decide that confrontation is its best approach.

The threat of trade actions has probably been the major driver behind the relatively modest appreciation of the yuan China has permitted over the past year, and the United States may see stiffer trade-policy actions as the only way to persuade China to move faster. Any short-term losses for the United States from such an approach will be smaller than those experienced by China, and would be outweighed--from the U.S. perspective--by medium-term gains from greater flexibility in China’s exchange rate.

While this view will not be expressed publicly by U.S. officials, it is likely to be the message impressed on the Chinese leadership in private.