The United States again is about to step up the pressure on China to allow the yuan to rise more rapidly, pointing out that a stronger currency will help China combat rising inflationary pressures.

The US has long complained that the yuan is artificially undervalued, giving China’s exporters an unfair cost advantage in world markets.

But with the latest round of high-level meetings between the two countries — dubbed the Strategic and Economic Dialogue — about to start in Washington, US officials are hoping that China might finally be persuaded to allow its currency to strengthen. They’ll argue that a stronger currency will benefit China by reducing the price of imported raw materials and commodities. And, they’ll argue that a stronger currency will make it much easier for the Chinese central bank to run an effective monetary policy.

But there are few signs that China will be persuaded by these arguments. Premier Wen Jiabao and other decision makers on the State Council appear far more concerned with ensuring strong Chinese growth and employment than with tackling inflation. They’re extremely wary of allowing the yuan to rise rapidly for fear of destroying the competitiveness of the country’s important export sector.

The yuan has risen by about 5% against the US dollar since last June, when China announced that it would abandon its two-year policy of pegging the yuan to the US dollar in favour of a more flexible exchange rate. But given that the US dollar has dropped sharply against most other major currencies in recent months, it means the yuan has weakened against other currencies.

China’s refusal to budge on its exchange rate means that the country will be forced to rely more heavily on administrative measures to combat rising inflation. And this will mean that producers will come under even greater pressure not to pass on rising raw material costs in the form of higher prices for consumers.

One sign of this came on Friday, when the consumer goods giant Unilever was hit with a two million yuan ($US308,000) fine for commenting on possible price increases, even though the company later cancelled plans to raise its prices.

The National Development and Reform Commission, China’s economic planning agency, criticised the Anglo-Dutch company for allowing its spokesman to tell the local media that detergent and soap prices might be raised because of high raw material prices. The NDRC said the comments had led to panic buying and disrupted market order.

But China’s refusal to countenance a higher currency is also hindering the process of rebalancing the Chinese economy in favour of consumption. In his latest newsletter, Michael Pettis, a professor at Peking University’s Guanghua School of Management, points out that for this rebalancing to take place, the transfer of wealth from the household sector to the corporate and state sectors has to be reversed. To date, the most important ways that wealth has been transferred away from the household sector, he says, have been “the undervalued exchange rate, the lagging wage growth, and artificially low interest rates”.

Pettis dismisses the argument that, because China’s inflation rate is higher than that of the US, China’s exchange rate has actually risen by about 8% against the US dollar in real terms since June. What matters, he says, is not overall inflation, but inflation in the tradable goods sector. And there has been relatively little inflation in the price of inputs in the US and tradable goods sector. In addition, he says, Chinese worker productivity has been rising faster than US worker productivity. After adjusting for inflation and the difference in productivity growth, he argues, it’s not at all clear that there’s been much real appreciation in the yuan against the dollar in the past year.

Pettis notes that the Chinese central bank has increased interest rates four times since last October, which has pushed lending rates up by about 1 percentage point. But, at the same time, inflation has risen by at least 2% or 3%, which means that real interest rates have fallen. This means that the savers — which are typically households — are losing even more money on their savings, while borrowers — typically the state and corporates — face even lower borrowing costs. As a result, the transfer of wealth from households to the state and corporate sector has increased.

However, rising wages are transferring wealth from the corporate and state sector back to the household sector. As a result, it’s difficult to determine how much the economy is actually rebalancing. It appears that household consumption is slowing, which suggests that the imbalances are getting worse, with the negative effect of declining real interest rates overshadowing the positive effect of rising wages.

At the same time, Pettis points out that the combination of rising wages and declining real interest rates favours the large capital-intensive industries, at the expense of small- and medium-sized companies, which tend to be labour-intensive. These smaller companies are largely credited with driving real, sustainable growth in China. In contrast, Pettis says, state-owned enterprises and government investment “have generated growth largely by jacking up wasteful levels of investment”.

And the fact that the Chinese economy is becoming even more capital-intensive is certainly not a good development. “The more important the capital-intensive sector is to the economy, and the more addicted these companies become to cheap capital that can be flung into wasteful projects, the harder it will be to rebalance the economy. All that increasing wasted investment is likely to be made viable mainly by continued transfers from the household sector, whether in the form of depressed deposit rates or in the form of direct subsidies funded by taxes and ‘fees’.”

As a result, Pettis argues, the task of rebalancing the economy and increasing household consumption will become even more difficult.

*This article first appeared on Business Spectator.

Peter Fray

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