In his confirmation hearings in January 2009, the US Treasury secretary Timothy F Geithner boldly declared that China was manipulating its currency exchange policies?keeping the yuan unnaturally weak to make the country?s exports more competitive. Geithner backed down soon after, taking the position that negotiations would be more beneficial all around than muscle-flexing. But it didn?t take a genius to know that, in time, muscle-flexing would resume at both ends. Indeed, it has. The US Treasury?s twice-yearly report on the currency policies of other countries is due in April, and there is growing speculation that it may finally and formally label China as a currency manipulator. Five senators have introduced legislation that would make it easier for the US to take corrective action against countries labelled as currency manipulators and 130 House members have sent a letter to the Treasury that asks it to issue a finding of manipulation. On the Chinese side, PM Wen Jiabao, himself, has pitched in to rattle back the sabre?insisting that his currency wasn?t undervalued. It is. By The Economist?s calculations, the yuan is 49% below its fair-value benchmark with the dollar. But as domestic politics drive US and Chinese leaders to flex muscles in their respective backyards, we want to emphasise the broader ramifications of the issue.
China?s policy of depressing its exchange rate undermines the competitiveness of other developing countries that compete more closely with China than the US or the EU, whose comparative advantage has a very different source?in technology, rather than in hard manufacturing. Paul Krugman says that?as most of the world?s large economies are stuck in a liquidity trap and unable to generate a recovery by cutting interest rates because the relevant ones are already near zero?China is not only engineering an unwarranted trade surplus for itself but also affecting an anti-stimulus pressure on large economies. But more important than what an undervalued yuan means to the rest of the world is what the undervalued yuan means for China. It is increasingly clear that a fixed, undervalued exchange rate is making it harder for authorities in China to control inflation and asset bubbles. That may yet be the most compelling reason for China to rethink the value of the yuan, certainly a lot more compelling than the aggressive rhetoric coming out of the US. Of course, the world will be better off if China reduces its trade surpluses and boosts domestic consumption, thereby correcting one of the most serious imbalances in the global economy.