Why China's Currency Manipulation Doesn't Matter

Timothy Geithner should stay away from cheap populism and hold his tongue about the yuan.

With just a few words in his Senate confirmation hearing, U.S. Treasury Secretary Timothy Geithner resurrected the long-held American accusation that China's penchant for money management is hurting the U.S. economy. President Obama -- backed by the conclusions of a broad range of economists -- believes that China is manipulating its currency, Geithner wrote in his prepared remarks.

As the argument goes, an undervalued Chinese currency makes the country's exports artificially cheap, giving Chinese goods an unfair competitive edge. Reduced demand for American goods hurts U.S. manufacturers and limits the size of the U.S. job market. China is taking jobs from the American heartland.

Blaming China for flailing U.S. manufacturing may be good domestic politics, but Geithner should hold his tongue. First, there is little evidence that a currency appreciation would have an effect on the U.S. economy -- let alone a positive one. Regardless, China will be compelled to appreciate its currency out of economic necessity in coming years. And because the United States has very few channels through which to push for appreciation, the yuan is better left alone.

Geithner's is certainly not the last Western complaint we will hear of China's currency, particularly now with an economic crisis in full swing. Yet many experts contend that there is actually no connection between the yuan and the health of U.S. manufacturing. Former Federal Reserve Chairman Alan Greenspan testified in 2005: I am aware of no credible evidence that ... a marked increase in the exchange value of the Chinese [yuan] relative to the dollar would significantly increase manufacturing activity and jobs in the United States.

The transition away from manufacturing is a long-term international trend that goes far beyond competition from Chinese exports. Jobs have been cut because technological improvements have simply made each worker more productive. A study by Alliance Capital Management (now AllianceBerstein) found that manufacturing employment in the world's 20 largest economies declined by 22 million workers from 1995 to 2002, while manufacturing output in those countries increased 30 percent. During that period, China lost 15 million manufacturing jobs, while the United States lost just 2 million.

If anything, Chinese currency intervention actually has several positive consequences for the U.S. economy. China has a large investment in U.S. debt, which helps keep U.S. interest rates low, allowing firms to make investments that would be unattractive at a higher cost of borrowing. Such investments increase the amount of capital available and thereby boost employment and the size of the economy. An undervalued yuan also reduces U.S. dollar inflation. And by keeping imports cheap, it increases the purchasing power of the average U.S. consumer.

Nor is the oft-cited U.S. trade deficit with China, which reached $246 billion in 2008, truly a result of currency manipulation or the resulting lower wages paid to Chinese industrial workers. In fact, the imbalance is the result of a gaping difference between U.S. savings and investment. In 2008, the U.S. savings rate was a mere 3 percent, whereas China's savings rate was a whopping 50 percent. In 2006, the ratio of domestic savings to national investment in the United States was 68 percent; meaning 32 cents of every dollar invested needed to come from foreigners. The same ratio was 118 percent in China, meaning that China sent abroad 18 cents out of every dollar the country invested. Unless these savings and investment patterns change, a rising yuan will have no effect on the U.S. trade deficit with China.

In any case, market forces will compel China to appreciate its currency in coming years for domestic reasons. Today, the People's Bank of China (PBOC) devalues its currency by purchasing U.S. Treasury securities. In doing so, it must first convert yuan to dollars, thereby releasing more Chinese currency into circulation, devaluing it and increasing inflation in the process. The PBOC sterilizes the purchase by simultaneously selling yuan-denominated PBOC bonds, which remove yuan from circulation, negating the inflationary effect of the intervention.

But sterilization is becoming problematic for the PBOC. First, the process has not been fully effective. Money-supply growth accelerated from 14.6 percent in 2004 to 17.8 percent in 2008, pushing China to a peak inflation of 8.7 percent in 2008, far above the government's target of 4.8 percent. Likewise, due to the immense scope of China's past intervention, the amount of PBOC bonds outstanding is now equal to more than half of the total amount of yuan in circulation. Demand for PBOC bonds is low, which means interest rates are rising and relatively high, about 5.31 percent currently, compared with U.S. short-term interest rates near 0 percent. The cost to the PBOC of receiving little or no interest on the U.S. bonds it owns and paying 5 percent interest on its own bonds is more than $4 billion a month, according to estimates by Goldman Sachs. China's foreign currency holdings, which total more than $2 trillion, are growing faster than the Chinese economy. In coming years, these realities will make intervention and sterilization untenable.

Pegging its currency to the U.S. dollar, the PBOC has also forfeited the ability to use monetary policy to manage its economy. As China's economy grows larger and less correlated with that of the United States', this will become increasingly problematic. There is also a large opportunity cost, as $2 trillion of foreign reserves could be invested in any number of beneficial internal projects.

There is neither need -- nor a way -- to browbeat China into appreciating the yuan sooner. Diplomatic pressure has had limited effect thus far. The United States also has the option of appealing to the World Trade Organization to impose trade sanctions, or it could impose sanctions unilaterally. Both are unlikely. The G-7 is currently split on whether currency intervention should be allowed, as other members have threatened intervention themselves in recent weeks. As for unilateral sanctions, they would be more detrimental to the U.S. economy than the policies they would seek to punish, even if China did not retaliate, which it likely would.

If the United States is looking to pressure China, perhaps it would do better to focus on issues where real results are possible. It should encourage China to honor the commitments it made in joining the WTO, such as reducing pollution and improving its human rights record. And finally, if it truly seeks to make its workers more competitive with those in China and elsewhere over long term, the United States should take a hard look in the mirror, and focus on raising worker productivity and reforming its educational system rather than on illusory exchange rate gains and protectionist policies.



The Road to Kabul Runs Through Beijing (and Tehran)

The new Great Game on the Silk Road is already underway. Has Team Obama gotten the memo yet?

The diplomatic and military surge into South-Central Asia that will define the Obama administration's early years has already begun. Joint Chiefs of Staff Chairman Adm. Mike Mullen and Centcom head Gen. David Petraeus have become regular visitors to Islamabad and Kabul. Vice President Joe Biden recently came through for huddled conversations, and veteran Balkan negotiator Richard Holbrooke has just embarked on his first trip as special envoy to the region. Enough congressional delegations are passing through that the Pakistani media jokes that there must a two-for-one sale on Pakistan International Airlines.

But perhaps people in Congress should be looking into ticket prices on China Air and IranAir as well.

Despite the flurry of American activity in the region, it's by no means clear that Washington is any closer to understanding the dynamics in South-Central Asia -- some that predate 9/11, and many that are new. On my recent trip to the region, I saw the incoherency unfolding for myself. To fix its strategy and hence, Afghanistan, the Obama administration will have to go regional -- and, crucially, look beyond the usual suspects for help, even if they are not naturally inclined allies.

We all know that Pakistan is a vital piece of the puzzle, but consider for a moment the consequences of a strategy that lacks a regional element. If the additional 30,000 U.S. troops being deployed in southern and eastern Afghanistan succeed at pushing Taliban fighters intro retreat over the border into Pakistan, they could massively destabilize that country's already volatile Northwest Frontier Province (NWFP), which is itself almost as populous as Iraq. U.S. troops would be squeezing a balloon on one end only to inflate it on the other.

On the Pakistan side, newly armed (with Chinese AK-47s) tribal lashkars (militias) would be unable to cope with the Taliban influx. Meanwhile, fewer armored carrots from a pro-democracy Obama administration have diminished the Pakistani military's willingness to support American priorities, evidenced by a sudden increase in attacks on NATO convoys in Peshawar and the Khyber Pass. Centcom is scrambling for new logistics routes through Russia, Uzbekistan, and Kyrgyzstan. As was the case under the Musharraf regime, the Army is more interested in American planes than policies.

But China, Saudi Arabia, and Iran are also becoming increasingly important -- not as neighbors of the chaos, like Pakistan, but meddlers in it. The United States is already failing to grasp not only the details of other powers' maneuverings in Afghanistan and Pakistan, but the extent to which these dealings could eclipse even the most brilliant U.S. shuttle diplomacy by Holbrooke.

China's long-term strategy is clear: It has become the largest investor in Afghanistan, developing highways to connect Iran and the giant Aynak copper mine south of Kabul. The Chinese have likewise financed the deep-water port at Gwadar on Pakistan's Arabian Sea coast.

Saudi Arabia, meanwhile, is widely thought to be funnelling unquantified sums to Wahabbi mosques and the Taliban, and the country's leadership is brokering the latter's negotiations with the Karzai regime.

For its part, Iran is building electricity plants to meet Pakistan's growing shortfall. More importantly, the country is renewing efforts to construct an Iran-Pakistan-India (IPI) gas pipeline, which both Pakistan and India badly need. Power outages in Pakistan today are on the rise, and they no longer even follow the predictable hourly rhythm of the past.

Yes, cooperation will have its price. The Obama administration may face greater pressure from both Pakistan and India to lift U.S. opposition to the IPI pipeline, to start. So too might the U.S. need to appeal to Iran to allow access to Afghanistan through the Iranian port of Chabahar and the Indian-built Zaranj-Delaram highway in western Afghanistan that connects the country's ring road to Kandahar and Kabul. (Some NATO allies are already rumored to be in dialogue with Iran about this option for access.) Building roads and controlling their usage has for centuries been the foundation of spreading Silk Road influence, as well as the key to success in the 19th-century Great Game. Today's struggle for control follows similar rules.

Clearly, the United States cannot resolve the Af-Pak problem alone. One way to align Afghanistan's and Pakistan's regional partners would be to follow a regional security model, much like those already adopted in Europe, East Asia, South America and even Africa. Such a self-sustaining mechanism in South-Central Asia must begin with a joint Afghan-Pak force empowered to conduct operations on both sides of the border, as recently proposed by Afghan Defense Minister Abdul Rahim Wardak. At the same time, the United States will have to accept Afghan and Pakistani negotiations with Taliban commanders. If ever these groups were glorified fringe phenomena of the frontier, today they are rooted in a deep Punjabi and Pashtun social base that cannot be eradicated anytime soon.

To clear and hold will require a Pakistani version of the Provincial Reconstruction Teams (PRTs) that have been deployed to some effect in Afghanistan. Rather than spending the civilian portion of the $1.5 billion in promised annual assistance (as foreseen in the Pakistan Enhanced Partnership Act) on USAID's usual roster of beltway bandits, Pakistani-led PRTs should be provided with the cash and supplies to hire thousands of local Pashtun to build roads, hospitals, and schools, and install power generators. NWFP policemen, who earn two-thirds their Punjabi counterparts (despite working in the most dangerous circumstances in the world), should get more pay. This process can begin from the Khyber Agency outside Peshawar and spread north and west towards the Afghan border, turning unsettled lawless areas into settled integrated ones. Rather than spreading weapons in an area already armed to the teeth, PRTs can run gun-for-work programs.

Here again, a strategy that reflects the region's changing dynamics is paramount. The original PRTs in Afghanistan need a sizable boost, and this should come in the form of Arab, Turkish and especially Chinese participation, under the auspices of the Shanghai Cooperation Organization (SCO), a regional security mechanism that may well soon expand to include Iran, and later, Afghanistan and Pakistan. Not only would this participation unlock thousands more stabilization- and reconstruction-oriented soldiers and civilians, but it would bind NATO's chief rivals for influence in the region into a common project. These are just some of the tradeoffs necessary to encourage a thaw with Iran, monitor China, stabilize Afghanistan, encourage political reform in Pakistan, and placate insecure India. If the U.S. cannot negotiate a modus vivendi among the nations and rivals of South-Central Asia, then perhaps China will.