Despite the optimism of Alan Greenspan, chairman of the US Federal Reserve, over the US government's willingness to curb spending, the single most important factor attributed to the United States' widening trade deficit is surging imports from China. But is pegging the yuan to a dropping dollar such a good move for China and will it help to retain price competitiveness in the long term? asks Rohit Kuthiala.

The United States' trade deficit stands at around 6 per cent of its Gross Domestic Product (GDP) - the highest level ever.

The dollar is weak and a weak currency is always a disincentive for imports and a stimulus for more exports, making domestic produce cheaper in value terms.

But wherever the dollar goes the yuan goes too. So a cheaper dollar means a cheaper yuan, which in turn works against the ever widening US trade deficit with China.

By pegging the yuan to the dollar China has assured its competitive edge with the US. But this is making Chinese producers more competitive compared to other low cost producers in economies like India, which are seeing their currencies appreciate steadily against the US dollar.

Beijing has so far shown no inclination to remove this exchange rate peg and freely float the yuan, despite intense pressure from the international community. Indeed, this exchange rate peg is widely blamed for the widening of the US's trade deficit and big increases in China's trade surplus.

Pegging the yuan to the dollar
But is pegging the yuan to a dropping dollar such a good move for China and will it help to retain price competitiveness in the long term?

At first glance, the US's $600 billion-plus trade deficit, coupled with the $100 billion jump in China's foreign exchange reserves in the last quarter, make it look as though currency pegging is an end to all trade deficit worries. But a second glance paints a very different picture.

China's overall trade surplus was a modest $32 billion smaller than in the late 1990s.
It accounts for only 10 per cent of US total trade, so the impact of a Chinese revaluation on the US trade deficit would be marginal.

Chinese exports include a lot of imported content, which a weak yuan is not able to source competitively. As a growing economy, China's need for oil - most of it imported - is on the rise; a weak yuan puts a lot of pressure on the price of oil, making it very expensive which can be a stumbling block for future growth. China has a trade deficit with most of its Asian neighbours.

The US dollar has depreciated in value by 16 per cent since 2002. The whole idea of fixing a currency exchange rate is to provide stability, which the yuan has not been able to achieve through the pegging to the US dollar. Between 1994 and 2001 the Yuan got dragged up 30 per cent by a rising dollar while all the other Asian countries were devaluing.

China does more trade with the European Union and Japan than it does with the Unites States, so the dollar peg is not giving it as much advantage as is popularly perceived.

A strong exchange rate will boost the purchasing power of Chinese consumers, enabling them to buy more foreign goods. But at present this growth depends too much on exports and consumption is weak.

An autonomous monetary policy
In the long term China is aware that to completely integrate in the global economy it will have to freely float its currency. It also recognises the advantages of an autonomous monetary policy. However the Chinese are not very sure of how to bring about this transition and are wary of the risk it poses.

Politically the Chinese do not want to be seen making any change in their currency regime under any overt foreign pressure. Financially they see it as very risky to abandon the exchange rate peg during a period of financial turbulence.

To prevent the yuan from rising against the dollar, the People's Bank of China is being forced to buy large amounts of American Treasury securities: this surely proves that the yuan is trading well below its true rate.

Much of the increase in reserves reflects inflows of short term speculative capital attracted by higher interest rates in China. A modest change can make the yuan overshoot on the upside, drawing in a lot of hot money and exacerbating capital spending and property bubbles.

Also there is an opposite danger; the yuan could collapse suddenly if speculators become disillusioned with the revaluation story and this would expose the Chinese economy to insolvency and inflation risks.

Currently there is no need for the Chinese to face such uncertainties as they have a healthy current account surplus and domestic inflation is well under control.

The Chinese will bring about this change to the currency exchange rate mechanism only when the markets are calm and capital flows are more or less balanced - not when the forward rates begin rising and markets are expecting the revaluation, which is not looking likely in the near future.

But the big question remains how do other countries making goods competing with Chinese prices continue to compete if there is no light at the end of the currency revaluation tunnel in the near future?

Despite its fall the dollar will continue to remain weak in the short term; interest rates in the United States are going to rise further in the long term. The Chinese economy is overheating as a fixed rate forces the Chinese to run a lax monetary policy. This is risking higher inflation and excessive bank lending.

A lot of similar international factors are also determining the economic fate of millions of people in poor economies like Bangladesh and Cambodia who are fighting the uphill task of matching China's low prices now that quotas no longer guarantee business.

Their best bet is to concentrate on improved customer satisfaction, flexibility and large amounts of productivity growth. And if their governments can help with a currency devaluation to complement international trade then they stand to not only retain their niche but also grow it.

Rohit Kuthiala has several years' experience in the global sourcing of fabrics and garments. He currently works for a leading global apparel supply chain company and is involved in the sourcing and distribution of garments globally for some of the leading European brands.