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Since China pegged the yuan against the dollar in 1994, and adopted a gently sliding peg in 2005, the yuan has become progressively undervalued against the dollar.
This is evidenced by the ever-widening gap between the demand for yuan created by foreign purchases of Chinese goods and private foreign investment in China, and the supply of yuan created by Chinese imports and private overseas investments.
Rather than permit the yuan to rise and equilibrate demand and supply, as Western market economies do, the Peoples Bank of China has intervened in currency markets, printing and selling yuan, and buying dollars, euros and other Western currencies. This makes Chinese products artificially inexpensive in the United States and U.S. products artificially expensive in China.
The magnitude of undervaluation of the yuan is revealed by the growing level of Chinese net intervention in currency markets, which was US$47 billion in 2001 or 19 percent of exports, and is on track to be $450 billion or 45 percent of exports in 2007. Although China has permitted the yuan to rise about 5.8 percent in the last year, modernization and rapid productivity growth raise the yuan's intrinsic value at least 7 and 8 percent each year. The yuan is now 40 to 70 percent undervalued against the dollar.
Federal Reserve Chairman Ben Bernanke has correctly concluded that China's yuan policy provides a subsidy on exports. By the scope of intervention, this is a 45 percent subsidy. However, the Bush administration has rebuked any suggested U.S. policy to offset this subsidy as protectionist -- a profoundly different view than the one it has adopted on other forms of industry aid offered by China.
The Chinese government is using the yuan peg as an employment policy to create more jobs for rural workers moving to cities than comparative advantage and free competition would require in international markets without these subsidies.
U.S. experiences with intellectual property and other protectionism teach that China will not relent on mercantilist practices until the United States is willing to take tangible trade actions to offset their effects.
Paulson traveled to China without a stick, and the Chinese dragon did not flinch.
Meanwhile, the United States is amassing a huge overseas debt, which the Chinese government now wants to convert into equity holdings in the United States. The U.S. government does not own stock in U.S. companies; now, ironically, it is paving the way for China's sovereign investment fund to do just that.
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(Peter Morici is a professor at the University of Maryland School of Business and former Chief Economist at the U.S. International Trade Commission. ©Copyright Peter Morici.)
