Tuesday, February 19, 2008

China Currency Catch-22

U.S. economic policy toward China has concentrated on getting China to revalue its currency, the yuan, with the objective of reducing its large current account surplus with the United States. The underlying theory is that a stronger yuan will raise China’s export prices, thereby reducing U.S. demand, and the weaker dollar against the yuan will increase China’s demand for U.S. products.

China began to loosen the fixed exchange rate between the yuan and dollar in July 2005. Since then, the yuan has risen 13.5% against the dollar, from $1=CNY8.28 to $1=CNY7.16. The higher prices of Chinese imports have begun to stoke inflationary fears in the U.S.

To cope with the U.S. economic slowdown and the prospect of recession stemming from the subprime mortgage crisis, the Federal Reserve Board has sharply lowered the fed funds rate from 5.25% in August 2007 to 3.00% on January 30, 2008. Financial markets expect another half-percentage point decline in the next month or two. The most important constraint that limits the fed’s ability to lower rates, and perhaps compel it to raise rates, is inflation.

Despite the steady revaluation of the yuan, the U.S. current account deficit with China increased in January 2008. As the yuan continues to appreciate against the dollar, projected at 7-10% in 2008, higher Chinese export prices will generate more inflationary pressure in the U.S.

The policies of lowering interest rates to prevent a recession or major economic slowdown coupled with a stronger yuan to reduce the trade gap, but which results in imported inflation, are incompatible. In this catch-22 scenario, what’s a poor secretary of the treasury and chairman of the fed to do?

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