Ever since the world lurched towards a new Great Depression in September 2008, the value of the Chinese currency has been the elephant in the room for global policy-makers.
China played a key role in the coordinated effort by governments to stabilize the world economy, injecting $586 billion into the financial system. At the same time, however, Beijing pegged its currency, the renminbi, to the US dollar at a rate of Rmb6.83 per dollar after allowing it to appreciate for three years.
As world leaders in the worst affected wealthy countries strove to maintain unity in the face of the downturn, the issue of exchange rates was quietly ignored. Now, with the global economy on track for an admittedly weak recovery, calls for currency appreciation have been increasing in both number and intensity.
While China sees the peg as part of a strategy for reviving growth, rival economies condemn it as artificial undervaluation designed to give its exporters a massive trade advantage. This pressure came to a head in the US in March when 130 members of Congress signed a letter calling on the Treasury to label China a currency manipulator.
The Treasury was due to make an announcement on whether to identify publicly any currency manipulators among major trading partners on 15 April, but at the last moment decided to postpone the decision.
As Simon Evenett, a professor at St Gallen University in Switzerland and an expert on world trade, says: Thanks to some deft diplomatic footwork, a confrontation between the US and China over the latters exchange rate regime has been avoided for the time being.
The guessing game
Those last four words are crucial. Financial markets are speculating on when and by how much not if the renminbi will be allowed to rise.
Wei Li, an economist at Standard Chartered Bank in Shanghai, expects Beijing to allow the currency to rise by 2% in the second or third quarter of the year. A strong rebound in export growth and rising pressure from the US have renewed market speculation of a possible near-term de-peg from the dollar, he says.
Mark Williams, senior China economist at Capital Economics and formerly at the UK Treasury, has pencilled in June as a likely date for a revaluation that will see the yuan appreciate 3% this year and 6% in 2011, ending the year at Rmb6.20.
He says that by then, the data fog around the Chinese New Year will have cleared. They want to be confident about the economic situation, and by June they will have had a couple of months of clear data.
Wei plays down speculation of a one-off revaluation of 35%, saying such a move raises too much risk for a risk-averse leadership.
Whoever is right, moves of 2%, 3% or 6% are chicken feed compared with what the most vociferous commentators are calling for. The Nobel Laureate economist Paul Krugman, who publicly backed the Congressional letter, called for a supplemental tariff of 25% to be applied on Chinese imports.
Fred Bergsten, director of the Peterson Institute for International Economics and a former US Treasury assistant secretary, says the renminbi is undervalued by 25% on a trade-weighted average basis and 40% against the dollar.
This competitive undervaluation of the Chinese currency is a blatant form of protectionism, he says. It subsidizes all Chinese exports by the amount of the misalignment, between 25% and 40%.
According to Bergsten, this currency misalignment is fuelling global imbalances at a time when policy-makers are striving to get the economy on a path of sustainable, balanced growth.
Chinas current surplus hit $297 billion last year down from $400 billion at the peak of the boom in 2007 but still 6.1% of its GDP, according to the latest data revision.
IMF chief economist Olivier Blanchard calculates that by 2014 Chinas surplus could account for 0.9% of world GDP greater than the entire US deficit, which will reach 0.6%.
Need for action
Mark Williams believes the Beijing authorities are aware of the need to take action to prevent a fresh crisis in the world economy. China does not want to see its relations with the rest of the world poisoned, he says. People say that China wont bend to foreigners pressure, but thats largely nonsense.
Like any country, they will do whats in their best interest, and if foreigners are threatening to bring a trade war down on their heads, they will take action.
Indeed, just days after US Treasury secretary Tim Geithner postponed the decision on currency manipulation, Ba Shusong, of the Development Research Center, the cabinets think-tank, said the peg was a temporary emergency measure that would be abolished at some point.
When the elephant finally stirs, the issue for Chinas trading partners in Asia as well as the West will be how significant the tremors will be.
The first impact from a currency appreciation should in theory be a fall in exports from China and a contraction in the current account surplus something that will appease US politicians and reassure the authorities at the IMF.
Meanwhile, the fall in the renminbi will cut the price of imports, which will make households feel richer and encourage them to spend, thus boosting domestic demand.
As Michael Pettis, finance professor at Peking University and a former Wall Street trader, says, this is the key point. A revaluation shifts wealth from the Chinese government and the manufacturing sectors to Chinese households, which is pretty much what is meant by rebalancing in the Chinese context, he says.
Not only will China have a safer and more balanced economy, but it will be more innovative, as consumption tends to drive innovation not production, and much more efficient.
Whats unknown is how the rest of Asia will be affected. On the one hand, it could be a blessing for Chinas Asian neighbours. Some, such as Hong Kong, Malaysia, Singapore and Taiwan, have all sought to keep their currencies undervalued against the dollar. A Chinese revaluation could give them an opportunity to bypass China and compete as an alternative supplier to the West.
However, revaluation could equally be a curse. Alicia Garcia-Herrero, chief emerging markets economist at BBVA in Argentina, says small Asian states will suffer from being so well integrated into Chinas supply chain. Exports from other Asian countries seem to be more of a complementary than a substitute to Chinese products, she says.
Roughly a fifth of their exports go to China. A 10% appreciation in the renminbi would cut exports from many south-east Asian countries by as much as 17% as demand for components slowed, her research shows. A fall in Chinas imports contains major consequences for the wider region as it is mainly imports from other east Asian countries which fall, says Garcia-Herrero, who is also a professor at Hong Kong University.
But Mark Williams warns against reading too much into local side effects of revaluation: Dont overdo it, he says. I dont expect the pace of change to be particularly great. The idea of 3% this year and 6% next year compares with the usual currency movements and is not very big.
Indeed, over the last 12 months the Indonesian rupiah has risen by 18% against the US dollar, while the Thai bhat is 10% up and the Singapore dollar 8% higher.
Pettis believes an appreciation of the renminbi which he sees as happening in the next month or so would lead to a realignment of a number of other Asian currencies that have run currency pegs. Several other Asian economies are facing domestic monetary pressures and so would like to see their own currencies appreciate, but they are afraid to do so until after China commits to doing the same, he says.
But he warns: Of course there will always be the temptation to appreciate less than trade competitors so as to gain market share. This is going to be a thorny issue.
Of course, concerted currency appreciation among surplus currencies is exactly what bodies such as the IMF are calling for. Currencies of a number of emerging Asian economies remain undervalued, substantially in the case of the renminbi, the fund said in its April World Economic Outlook. In emerging economies with excessive surpluses, monetary tightening should be supported with nominal effective exchange rate appreciation as excess demand pressures build to facilitate demand rebalancing.
Ultimately this process should be part of a coordinated strategy to deliver a rebalanced global economy, the lack of which was a cause of the financial crisis.
Another reason why economists see June as a likely time for Beijing to take the first step towards appreciation is the timing of the G20 Summit in Canada. When Geithner postponed the currency report, he specifically said over the next three months that they would be pursuing other avenues, says Mark Williams. That suggests that China will be coming under pressure by the end of June when G20 leaders meet. If China leaves it much beyond that, then it will be harder for them to act without being backed into a corner.
Pettis believes the G20 can be the right forum for successfully applying pressure on China to allow appreciation of its currency. He points to public calls in April by governors of the central banks of India and Brazil fellow members alongside China of the key Bric (Brazil, Russia, India and China) caucus for faster renminbi appreciation.
The G20 may very well be the best forum for this discussion, because it generalizes the debate and allows China to claim that they are not reacting to rich-country bullying, he says.
But it is not only Asian nations that need to take action. Deficit-laden countries such as the US need to improve their fiscal position, while surplus countries including Germany, Japan and Opec (Organization of the Petroleum Exporting Countries) nations need to boost domestic demand. As Pettis points out: The global imbalances consist not just of US overconsumption and Chinese overproduction, but of imbalances in nearly every major economy.
While it looks increasingly likely China will soon embark on currency reform for the first time since June 2008, that is unlikely to be the end of the story. While western countries are already acting quickly for their own reasons to cut deficits, action by surplus countries will take longer to bear fruit. Whatever Beijing does, it will meet with impatience in the US, Pettis notes.
The possibility of continued political anger within the US and demand for tariff hikes that would threaten a Sino-American trade war cannot be ruled out. After all, it is the Chinese year of the tiger.