It’s hardly coincidental that the Chinese currency, the yuan, has glided to a record high just days before Chinese President Hu Jintao is due to arrive in Washington for talks with US leader Barack Obama.

Yesterday, the Chinese central bank set the mid-point for daily trading at 6.59 against the dollar, the first time the critical 6.6 level had been breached. The currency is only permitted to trade 0.5% above or below the rate set by the central bank on any given day.

Earlier this week, US Treasury Secretary Tim Geithner left little doubt that ongoing trade frictions will be a key item of discussion at next week’s meeting between Obama and his Chinese counterpart.

The Obama administration has long complained that the yuan is undervalued, which gives Chinese exports an unfair advantage by making them artificially cheap. Last June, Beijing announced that it was unpegging its currency against the US dollar, and would allow the currency to respond more to market forces, and since then the yuan has appreciated 3.5%. But Geithner made it clear the US administration wanted more — it wants the yuan to rise more rapidly.

Geithner also voiced other frequent US criticisms of Chinese trade policies, and called for “a more level playing field for US companies that compete with Chinese companies in China, in the United States and around the world”. He urged China to cut implicit state subsidies to companies — such as by providing low-cost finance, land and energy. In addition, he said, China should stop the theft of intellectual property from foreign companies.

And he warned that unless China changed its policies, it could find its access to US markets and US high-tech products threatened by a political backlash. He warned that anti-Chinese sentiment in Congress was “something China is very attentive to and they need to be”.

But while the yuan’s latest rise is undoubtedly neatly timed to alleviate tensions ahead of Hu’s visit to Washington, there are strong domestic reasons for China to allow its currency to appreciate.

Chinese policymakers are increasingly concerned with tackling inflation, which rose above 5% in November for the first time since early 2008. But their task is made all the more difficult by an undervalued currency.

Chinese exporters convert their foreign currency earnings into yuan at the Chinese central bank. Given that China accumulated a massive trade surplus of $183.1 billion in 2010, this represents a huge injection of money into the world’s second largest economy.

Even though the Chinese central bank has tried to counter this effect by repeatedly increasing the level of reserves that banks must hold against their deposits, their actions have not been enough to prevent a steep rise in the money supply.

Allowing the yuan to rise will not only reduce this inflationary monetary pressure, but it will also put downward pressure on the price of imported goods — including commodities, which would help relieve domestic cost pressures.

But, at the same time, Chinese policy makers are deeply worried that allowing the yuan to appreciate too far would undermine the competitiveness of Chinese exporters, and cause them to lay off workers.

As a result, it’s far from certain that the yuan’s rise will continue once next week’s talks between Hu and Obama draw to a close.

*This article was originally published on Business Spectator.

Peter Fray

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