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On Chinese Currency, Be Careful What You Wish For

Democrats and Republicans don’t agree on many economic issues, but one point is an article of faith in both parties: China keeps its currency artificially undervalued, which boosts Chinese exports, restrains imports and steals jobs from deserving Americans.

Much as I like to hear our politicians singing from the same hymnal, it might be time to turn the page.

China took a significant step toward liberalizing its economy and answering its foreign critics over the weekend. As of yesterday, Beijing now allows the Yuan to float within 1 percent, up or down, from the benchmark exchange rate against the U.S. dollar that China’s central bank establishes each day. The previous daily limit was 0.5 percent. Under the tighter former restriction, the Yuan appreciated by an average of 4.4 percent per year over the past five years.

But the Chinese currency has not appreciated at all against the dollar thus far in 2012, and it actually fell yesterday in the first day of trading under the new limit. Short-term movements, or the lack thereof, do not necessarily mean the long-term trend has reversed; yet traders are evidently in no hurry to snap up the Yuan, currently valued at a little less than 16 U.S. cents, at a time when Chinese economic growth is slowing and the country faces a leadership transition. The belief that the Yuan continues to be significantly undervalued may already be more a matter of faith than of fact.

This brings us to the question of why Chinese authorities chose this moment to relax their currency controls.

Part of the answer is that this move is simply part of a long-term effort to integrate China’s economy with the rest of the world, mirroring the rise of Chinese wealth, influence and ambition. China has steadily allowed greater economic (though not political) freedom in many areas, including trading of its currency beyond its borders - sort of - in the financially independent markets of Hong Kong, as well as more foreign ownership of Chinese corporate shares and more foreign travel by Chinese citizens.

Another part of the answer may be that China sincerely wants to smooth its relations with major trading partners. Though the Chinese have long been careful not to appear to bow to foreign pressure to increase the Yuan’s value, the currency’s recent stability makes the more liberal trading rules look like a low-cost gesture.

I doubt that Chinese generosity or goodwill have much to do with the decision, however. Like all countries, China acts in what it believes to be its own best interest. The Chinese just take a relatively long-term view of that self-interest when compared to Western democracies, which tend not to look far beyond the next election. The Chinese are doing what we want because they think it is better for them, not because it might be better for us.

I can see at least three reasons why Chinese leaders would conclude that a stronger Yuan serves their interests, even if it makes life harder for the country’s powerhouse exporters.

First and most obviously, a stronger Yuan helps control Chinese inflation by making imported commodities cheaper. Oil, soybeans, iron and many other materials produced all over the world are traded in dollars. A stronger Yuan makes those items cheaper for China’s companies and consumers. This, in turn, makes it easier for China to loosen the reins on credit, which is already abundant for big state-owned enterprises but hard to get for smaller firms. These maneuvers will help drive China’s economy away from its over-reliance on exports and toward greater domestic consumption. China and its trade partners all want this. On this level, China’s liberalizing move will be seen as a win-win.

Less optimistically, China’s economic decision-makers are clearly finding themselves in a bind: They have no attractive place to put their nation’s vast foreign exchange reserves. The dollar has been relatively strong since the financial crisis only because sovereign debt problems in the eurozone have looked even worse than our own trillion-dollar-a-year fiscal morass. Japan’s yen has emerged as the biggest safe-haven currency, which is bizarre when one considers the extent of that country’s economic and budget concerns.

In the short term, a rising Yuan would limit China’s problem because it would shrink the country’s trade surplus, and thus the growth rate of its reserves. In the longer term, however, a freely floating Yuan could eventually emerge as a global reserve currency in its own right - a rival to the U.S. dollar, and a check on what amounts to an American monopoly on do-it-yourself global money. By the middle of this century, China might enjoy cheaper access than its rivals to foreign capital, which is one of our nation’s greatest strategic advantages.

Third, the dollar’s role as the dominant global currency gives Washington a choke hold on the global banking system. We can threaten countries like Iran and North Korea with isolation from the world monetary system, and we can enforce our threats through banks in foreign countries - including China - by threatening to bar those institutions from participating in our financial markets or interacting with our companies. For the Chinese, whose view of the merits of dealing with such regimes differs widely from our own, this is a major strategic disadvantage, which they might be able to neutralize if the Yuan emerges as a rival to the dollar. They would be able to match Washington’s threats with threats of their own: Anyone who cooperates with sanctions against Chinese firms or targeted nations would be barred from China’s financial system.

So the Chinese are playing their own game by making the moves we want them to make. Overall, a more open and transparent Chinese economic system is, in fact, a good thing for the rest of the world, America included. Our manufacturers and farmers are already benefiting from the gradual strengthening of Chinese currency. The New York Times reported this weekend that American retailers are making special efforts to sell luxury goods to Chinese tourists.

Yet our long-term interest requires that we make strategic moves to counter and complement China’s. Mainly, this means getting our government finances under control at all levels, and building a leaner, more efficient, more flexible economy that can continue to attract all sorts of capital - financial and human - in the decades to come.

Larry M. Elkin is the founder and president of Palisades Hudson, and is based out of Palisades Hudson’s Fort Lauderdale, Florida headquarters. He wrote several of the chapters in the firm’s recently updated book, Looking Ahead: Life, Family, Wealth and Business After 55. His contributions include Chapter 1, “Looking Ahead When Youth Is Behind Us,” and Chapter 4, “The Family Business.” Larry was also among the authors of the firm’s book The High Achiever’s Guide To Wealth.

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