Fed policy creates crunch moment for Chinese yuan

August 11, 2011

By John Foley
The author is a Reuters Breakingviews columnist. The opinions expressed are his own.

China’s suppression of its currency creates more problems than benefits. The U.S. Federal Reserve’s pledge to keep rates near zero for the next two years provides the perfect reason to do something about it. The yuan’s rise in the last three days sets the right tone.

The Fed’s strategy is likely to drive the weak dollar downwards. Normally, China might be minded to follow to ensure that its exporters don’t become uncompetitive. The yuan has appreciated less than 7 percent against the dollar in the past three years.

The catch is that the cheaper the dollar gets, the harder China must work to maintain the peg. To mop up dollars, the central bank issues new yuan, which it then swaps for government bonds to avoid fuelling inflation. With Chinese one-year Treasuries yielding 3.5 percent, and U.S. Treasuries yielding next to nothing, that creates a drain on the economy.

Meanwhile China’s $3.2 trillion of foreign currency reserves would get bigger and harder to manage. They have doubled in size since the beginning of 2008, and U.S. Treasuries are still the safest and most liquid place to store them. China’s policymakers want to diversify away from buying U.S. bonds, but the currency treadmill makes that a pipe dream. A cheaper dollar would also tend to push up prices of traded commodities, threatening to add to China’s already-high 6.5 percent inflation.

An answer is to let the yuan appreciate — a lot. The International Monetary Fund has suggested that a rise of around 20 percent might be in order. That would make imported commodities more affordable, stem reserves accumulation, and put more spending power in the hands of businesses and consumers.

Beijing may resist doing anything that hurts the export sector. But while manufacturing activity is slowing, this week’s data showed that retail sales and industrial production are still resilient. Despite worries of a weakening global economy, the trade surplus widened to $32 billion in July, suggesting exports will be robust.

In any case, if China needs to prop up growth it can release some of the deposits its banks have been forced to keep in reserve, or reverse the country’s first-half fiscal surplus. Those options make a stronger currency less scary. With the Fed making grand monetary gestures, it’s a good moment for China to do the same.

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