The Yuan Finally Rises—Now What?

With the dollar falling to record lows against the euro and the yen, no one is watching the yuan. Not even the American presidential candidates who had been blaming U.S. trade woes on Chinese currency manipulation. But look: after years of increasingly anguished Western calls for China to free its currency, Beijing finally has. The yuan strengthened against the dollar by 7 percent last year, and an additional 3 percent so far this year.

If the United States is starting to get the yuan it asked for, it is not seeing the results it expected. The American argument was that as the Chinese get richer, the yuan should get stronger, so they can buy more U.S. goods and help correct the huge U.S. trade deficit with China. The Bush administration spent plenty of time spotlighting China's "unfair" exchange rates at the IMF and G8 summits last year. Hank Paulson's appointment as Treasury secretary was trumpeted as a way to gain traction on the currency issue in particular, because as chairman of Goldman Sachs he developed strong relations with Chinese officials. But the rise of the yuan has not had an impact on the trade balance.

To those who've crunched the numbers, it's not a surprise. As American economists like Fred Bergsten have noted, Chinese labor is so cheap in comparison with American labor that it would take at least a 40 percent appreciation of the yuan against the dollar to make a dent in imbalances. What's more, Beijing's reasons for easing up on the yuan have nothing to do with ties to Paulson, much less concern about candidates like Senators Clinton and Obama, who threaten to punish "currency manipulators."

China has its own worries, particularly inflation. Last week, when Prime Minister Wen Jiabao delivered his annual report to China's Parliament, he stressed the twin perils of overheating growth and inflation. Wen told delegates it was vital to "keep structural price increases from turning into significant inflation." Consumer inflation hit 4.8 percent in 2007 (the government's target was 3 percent). In January, it surged to 7.1 percent, an 11-year high.

A stronger currency is seen as a key weapon against inflation. Aside from food inflation, "what concerns policymakers is inflation related to raw-material costs," says Qing Wang, Morgan Stanley's chief economist for Greater China. A stronger yuan would reduce the price of dollar-denominated oil, steel, copper and other minerals. Last month the central bank said it would "further bring out the role of the exchange rate" to promote balanced growth.

It will have to go much further to help U.S. businesses, but already the rising yuan is hurting Chinese exporters by making their goods less competitive abroad. The exchange-rate shifts have helped knock as much as 20 percent off profits at some small and midsize firms, which represent 71 percent of jobs in China.

Economists now expect China's currency to gradually appreciate by some 10 percent over the next year. Smaller firms will likely continue absorbing the appreciation, as well as the extra costs of fuel and raw materials, in tighter profit margins. At the same time, they are also under pressure from new labor and human-rights laws, pushed by the West and some Chinese. Pensions and health insurance are now compulsory, and firing harder. Small firms complain that adds roughly 20 percent more to their costs. Wang Jianping, a small Wenzhou-based shoe manufacturer whose costs went up more than 20 percent last year, thanks to both exchange rates and labor, believes that forcing Chinese small business to adopt such Western laws is like judging "a primary-school student with the standards of a college student."

What do Americans make of all this? Mostly, they aren't impressed. U.S. Democratic Congressman Sander Levin has been one of China's staunchest critics, pressing for labor rights to be written into trade deals. He says the recent renminbi appreciation is "a positive development," but "more rapid and sustained appreciation is necessary," while any suggestion the renminbi is near a fair market value is "simply false." As the United States heads into recession, others are now beginning to complain that currency appreciation is actually a bad thing. National Association of Manufacturers vice president Frank Vargo says yuan appreciation is "definitely" stoking U.S. inflation as China-made goods rise in price.

For now, the plummeting dollar has dampened the fervor of last year's U.S. debate on the yuan. That could change. The Democratic contenders have both ratcheted up their rhetoric on the yuan to clinch blue-collar support, and John McCain is a notorious free trader. The election outcome probably does not matter, however. What the record shows is that China will free the yuan (or not) for its own purposes.