Scapegoating China

Make no mistake about it. The yuan is clearly undervalued, especially after several years of Chinese deflation. But U.S. manufacturers are picking on China for all the wrong reasons.

And the Bush Administration is all too eager to adopt their agenda, always following the motto: "First, let's blame somebody else."

Yet, U.S. job losses have little to do with an undervalued yuan. Instead, they have everything to do with the effects of the recent recession — and with the inability of the Bush Administration's economic team to restore confidence through competent economic management. After all, it is such confidence — more than anything else — that stimulates sustainable economic activity.

It is also worthwhile remembering that most low-paying, low-skilled U.S. manufacturing jobs have long left the United States in the 1980s and early 1990s. This process brought about a sharp social re-adjustment process. While these changes were painful, they also laid the strong foundations for the economic growth registered during the mid- to late 1990s.

Those who suffer the most from an undervalued Chinese currency today are the same people who were the beneficiaries of U.S. adjustment back then. Mexico is especially hard hit.

Rather than zero in on China's currency, Secretary Snow should worry about rising job losses of white-collar U.S. workers. Their U.S. jobs are increasingly transferred to underpaid counterparts in India — a country that, by the way, has a freely floating exchange rate.

Concerns are rising that there might be no replacement jobs for these white-collar workers, who are often highly educated and well-compensated. This may have long-term negative wealth effects on some of America's high-income strata — which implies much greater multiplier effects than previous adjustments.

As is so often the case in this administration, Secretary Snow is rigorously advocating a policy which has not been thought through. In particular, it is important to reflect on the unfortunate consequences for China itself — if it were to follow the misguided U.S. advice.

The economic experience of emerging and advanced countries — and the preponderance of research on the subject — suggests great caution in going too far too fast in weaning China off its pegged currency.

True, fixed currencies are a thing of the past. Most economies will see the benefits of a more efficient resource allocation — at least theoretically — from the shock-absorbing function of a floating exchange rate regime.

However, there are three key assumptions to be met. First, the country in question must have a fully liberalized capital account — that is, it must permit the unencumbered in- and outflow of capital.

Second, strong institutions are required, such as a well-versed central bank and regulatory agencies. Third, there must be a well-capitalized and supervised domestic financial system. China does not meet any of these three criteria.

Moreover, it has also been firmly established during the 1980s and 1990s — when many countries labored hard to meet these criteria — that proper and careful sequencing is of utmost importance.

Those countries that took hasty steps, almost without exception, experienced a collapse of their domestic financial system. That usually had serious consequences for these countries’ real economies, leading to falling living standards and political turmoil. On the other hand, countries which proceeded in a deliberate fashion, often reaped the desired benefits.

Anybody who knows anything about China understands its reluctance to liberalize its capital account, its weak institutions — and, most of all, its insolvent banking system.

While estimates vary, non-performing loans in the Chinese banking system may be as high as $1 trillion — or the equivalent of 70% of the country's GDP.

Under these circumstances, to recommend haphazard abandonment of the admittedly suboptimal peg without first implementing the necessary reforms — and doing so in the proper sequence — is simply foolish. Worse, it risks the collapse of China's financial system.

Ironically, such a development would likely lead to a rapid devaluation of the freely floating yuan, something that economists refer to as "twin crises," namely the joint occurrence of a financial as well as a currency crisis.

Any benefit the United States might hope to have reaped from letting the yuan float would then be reversed. The economic and social consequences of such a scenario for China would be staggering.

For years, Chinese authorities have emphatically insisted on an annual growth rate of at least 8%. And they have warned that anything below this target would be socially intolerable.

Should the Chinese financial system come apart, this surely would lead China down such a path. Rising unemployment — in a country without social safety net — would also cause dire political fallout.

Given China's dominant role in the region, the destabilizing effects — financial, economic and political — could extend well beyond the People's Republic.

In that light, whatever economic costs — if any — the United States might incur from China’s undervalued currency looks like a bargain. Another financial meltdown in Asia might well choke off the impending global economic recovery.

Then again, some cynics may argue that there are those in the Bush Administration who adhere to grandiose nation-building plans. In their view, it may very well be the ultimate victory to politically weaken and destabilize China via economic pressure on the currency front.

Naturally, as is the case with post-war Iraq, proponents of this agenda are unlikely to have a viable plan for The Day After.