China’s currency reforms may make ‘get tough’ promise moot

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Even with the recent intervention by the People’s Bank of China to support the yuan, since February the Chinese currency has lost about 1 percent of its gains against the dollar because of the precipitous slowdown in economic growth there. Analysts estimate China’s annual growth rate has fallen to about 6 percent this year from more than 10 percent last year.

William R. Cline, senior fellow at the Washington-based Peterson Institute for International Economics, says China has been responsive to global demands concerning its exchange rate. He said the yuan’s rise against the dollar and other major currencies from 2005 to 2007 was instrumental in reducing China’s chronic trade surplus with the United States and the rest of the world from 10 percent of economic output in 2007 to only 2.8 percent last year.

Mr. Cline estimates that if China allows the currency to keep appreciating by about 3 percent a year — its pace until this year — that would eliminate the country’s trade surplus by 2017.

Thus, Mr. Cline concludes that the huge trade imbalance between the U.S. and China — which has “widely been seen as the most serious source of global imbalances” and is believed to have contributed to the 2008 financial crisis — appears to be in the process of mending itself, thanks to policies China adopted under pressure from the U.S., Europe and other Group of 20 economic powers.

Consumers unaffected so far

While China is making progress in the face of long-standing demands that it loosen restrictions on its currency, so far not all of the yuan’s rise has been passed through to U.S. consumers. The disconnect may be feeding the impression among politicians and the public that China continues to suppress its currency.

A study by the New York Federal Reserve found that as recently as a year ago, there had been no widespread price increases in Chinese imports despite the significant rise of the yuan. The disconnect appears to be because Chinese exporters have absorbed much of the cost of the currency realignment, keeping their prices low in a bid to retain their share of the lucrative U.S. market and avoid scaring off U.S. customers.

But that may be about to change.

Since June 2010, when China started allowing its currency to rise again after a lull during the recession, Chinese exporters have passed through about two-thirds of the 7.45 percent increase in the yuan against the greenback by raising the prices on Chinese products, according to the Labor Department’s import price index.

The Chinese price increases may be about to accelerate, according to Morgan Stanley. The Wall Street firm is predicting that Chinese exporters will not be able to keep absorbing costs much longer and soon will be forced to start jacking up prices more vigorously.

Profit margins of Chinese exporters have fallen by between 20 percent and 30 percent since 2004, Morgan Stanley estimates, affected both by the falling value of their dollar earnings on exports, and by accelerating wages in Chinese factories that have been rising an average of 14.5 percent a year for the past decade.

The monumental profit squeeze most likely has reached the threshold of pain, said Morgan Stanley analyst Spyros Andreopoulos.

“Sooner or later, Chinese exporters will have to raise their prices to defend margins,” he said, noting that anecdotal evidence suggests that “many Chinese exporters are increasingly doing exactly that.”

The rise in prices eventually will have the effect sought by political leaders — a rebalancing of trade as Chinese exporters become less competitive and U.S. manufacturers become more competitive, he said. But it also will have the not-so-welcome effect of generating a potentially significant rise in inflation as price increases for Chinese goods feed through to the overall level of prices, he said. The inflation pressures would be even greater if China’s price increases lead to me-too price increases by competitors in South Korea, Taiwan and elsewhere, he said.

Inflation threat seen

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