Why China Should Not Revalue

Last week's setback in global equity markets was a warning shot aimed at the US. The message: don't push down the dollar. A substantial realignment of the Asian currencies against the dollar would destabilise the world economy and could snuff out reflation hopes both in Asia and the US. The good news is that Beijing is continuing to ignore US pressure for a revaluation of the Chinese currency.

The renminbi has become the de facto anchor currency of the Asian region. Advocates of revaluation argue that China's currency peg amounts to a form of unfair trade and is one of the main causes of the US current account deficit. That deficit, in turn, is cited as an indicator of US job losses and the most visible symptom of a world that is extremely unbalanced.

The problem with this view is that those calling for a revaluation in Asia's anchor currency do not seem to realise that extreme imbalances in the world economy are a welcome consequence of the specialisation that accompanies globalisation. It is a mistake to analyse the US domestic outlook from the perspective of a nation state with closed borders. The world promoted by US-style capitalism is porous. Capital and goods flow freely from region to region. Economic policy needs to be evaluated in a global context.

China's dogged adherence to its peg is a powerful tonic for global and US growth. The peg in effect forces China to import US monetary policy, which is currently hyper-stimulative. China's short-term interest rates are 2-3 per cent, its money growth is 20 per cent and credit growth is 25 per cent. China's intervention also supports the Federal Reserve's efforts to keep interest rates low.

It would be good for global growth if other regions followed China's lead. US officials continuously call on Europe's policy leaders to provide more policy support, and rightly so. There is no reason for short-term rates in Europe to be higher than in the US. The European Central Bank could take advantage of the rising euro, reduce short-term interest rates to US levels and intervene to push the currency lower. The intervention would help flatten the US yield curve even further.

What would happen if the Asian currencies were pushed higher by a 20 per cent revaluation of the Chinese peg? The initial shock would push Asia into a temporary downturn reminiscent of 1998. A coincident collapse in Asian central bank intervention would push up US interest rates, in contrast with the drop in bond yields in 1998, when the current account deficit was financed by an abundance of private foreign capital. Consumer spending would be hit by rising borrowing costs and higher import prices. Although the weakness in the dollar would boost import-competing industries and exporters' profits, multinationals operating in Asia would be hurt.

Overall, a realignment of the Asian currencies would be a deflationary shock for the world. Asia would be hit especially hard. The net effect for the US would be neutral at best and more likely negative. The US economy is more interest rate-sensitive than currency-dependent. It is doubtful that even a 20 per cent drop in the dollar would do much to diminish US households' vast appetite for goods made by Asian producers.

Markets adjust one way or another to disequilibrium. Sustaining the peg in China will result in an eventual appreciation of the real trade-weighted renminbi through rising domestic price inflation. Prices, which were falling last year, are now creeping higher and China's trade surplus is shrinking. A continuation of these trends would lead to increased global pricing power, acceleration in capital spending, an eventual upturn in global employment and sustained US consumer spending.

The rumblings in global equity markets since the Group of Seven communique last month that called for "more flexibility in exchange rates" have made little impression on the US administration. President George W. Bush repeated his demands this week for China to adopt a "monetary policy that is fair" - meaning it should revalue. Perhaps the bond rally has assuaged any fear of a backlash from the credit markets. If that is the case, the analysis is superficial and the conclusion wrong. The trade-weighted dollar has dropped a measly 2-3 per cent. Japan and China have not stopped intervening. Bonds rallied because stocks shuddered at the deflationary implications of a drop in the dollar.

The main risk in the global outlook is the apparent failure of the US administration to understand the bigger picture. The US is the world's champion of free markets and capitalism. A retreat into protectionist-type policies of the sort being discussed in Washington would do irreparable damage to the global economic outlook. Hopefully, US employment will rise in time to avert such a move. Meanwhile, markets will act nervously as the risks of a protectionist backlash in the US increase. The best thing Asia's policymakers can do to avoid this outcome is to keep intervening in the currency markets.