Yen for Yuan China Is

¶ … Yen for Yuan China is trying to hold down the value of the yuan to compensate for its own economic weakness. Primarily, it is an effort to increase its competitiveness against European, Japanese and South Korean manufacturers for selling into the U.S. market. China's weak currency policy is really just a form of protectionism that makes Chinese goods unfairly cheap against those of its global competitors.

In the case, China has maintained the same fixed exchange rate since 1996 resulting in a massive increase in foreign exchange reserves with an increase of 47% in 2004. This phenomenal increase has been in large part fueled by a yuan that is estimated to be undervalued by as much as 20% to 30% against the dollar. China expects and is already experiencing many benefits from its weak currency policy. First, and foremost, it is selling more goods into foreign markets, most notably the U.S. which had a $162 billion trade deficit with China in 2004.

This is because the weak currency policy keeps the price of its exports artificially low. and, certain Chinese industries such as agriculture are protected domestically because the price of its imports is artificially high. An increase in China's favorable trade balance has been followed by an increase in manufacturing jobs and, thus, an increase in national income. This, in turn, helps fend off deflation that would otherwise occur with structurally weak domestic demand.

This is very important for China's fragile economy which is in a transition from money-losing, state-owned enterprises to market-driven businesses. The later must be successful enough to absorb job losses from the former; otherwise, China would have to confront massive unemployment that would threaten its economic and political stability. Another secondary benefit to China is that its capital markets are becoming more attractive to investors, although this has caused some challenges for managing the supply of money.

Provided that consumers did not shift demand away from Chinese imports, they would pay the full cost of the tariff or $55 billion. In the real world, this scenario is unlikely to happen because tariffs would increase the attractiveness of domestically manufactured goods provided that the good is relatively price elastic as is certainly the case with most Chinese manufactured goods. One could expect a dollar depreciation of 2.5%.

Because the 25% appreciation in the yuan represents the amount it is currently undervalued against the dollar, one can expect a significant drop in the demand for China's goods. However, the appetite for foreign goods in general will still be strong as the U.S. turns to China's competitors such as Europe, South Korea and Japan. China relies on a fixed exchange rate rather than letting market forces invoke needed exchange rate adjustments.

To maintain its fixed exchange rate, the Bank of China has had to issue more yuan to buy up dollars that are flowing into the country. This has meant a dramatic increase in China's money supply which as risen from 19.6% in 2003 to 14.6% in 2004. As a result, inflation has now displaced deflation as the main economic policy concern with the government worrying about the outfall of the asset bubbles inflation has created, particularly since banks already have $500 billion in nonperforming loans from state companies and property developers.

As a solution, China might consider some yuan appreciation or develop policies to encourage capital outflows that would decrease pressures for expanding the money supply to buy up dollars. Yes, undervalued currency does come at a.