Smith Faculty Opinion Article	August 8, 2006
By Dr. Peter Morici, Professor of International Business EMAIL WEB SITE

Henry Paulson: Defender of the Yuan?

Chinas currency manipulation imposes severe economic costs on the United States, Europe and many developing countries that compete with China. Persuading China to revalue its currency should be new U.S. Treasury Secretary Paulson's top priority. Sadly, Mr. Paulson has already indicated he will continue the failed policies of his predecessor, John Snow.

In 1995, China fixed the value of the yuan at 8.28 per dollar. In July 2005, it adjusted this peg to 8.11 and announced the yuan would be aligned to a basket of currencies; however the yuan still tracks the dollar closely, is currently trading at about 7.97, and remains at least 40 percent overvalued.

Chinas trade surplus with the United States has grown from $34 billion in 1995 to more than $200 billion, and its global trade surplus exceeds $400 billion.

These surpluses create a demand for yuan that exceeds supply in currency markets, and should drive up its value to 4 or 5 yuan per dollar. Instead, Chinese monetary authorities subvert market forces by selling each year more than $200 billion in yuan, and stashing in its vault the U.S. and other foreign currency it accepts as payment. Those purchases amount to about 9 percent of Chinas GDP, and create a 25 percent subsidy on exports and a tax on imports.

This situation encourages factories, especially in durable goods industries like automotive products and more sophisticated electronics, to move to China, and redeploys U.S. and European workers into lower productivity activities. This lowers U.S. and EU GDP and growth.

An undervalued yuan pushes down prices for Chinese products, such as TVs and furniture, but it causes inflation in many other sectors of the global economy. Every time a factory job leaves the United States or EU for China, global oil consumption and prices go up, because China uses petroleum to generate electricity very inefficiently and workers move from the countryside into the cities.

This inflation requires the Federal Reserve and European Central Bank to raise interest rates. Essentially, these institutions must limit growth in the West, so that China can grow at more than 10 percent, and have become unwilling accomplices to Chinese mercantilism.

Similarly, Chinas currency practices steal exports of labor intensive products and growth from other developing countries. China is the bully boy at the cafeteria line hogging all the pie.

Chinas mercantilism is an important reason free trade is increasingly resisted by voters and politicians around the globe, and the Doha Round is failing.

Subsidizing exports and taxing imports is protectionism by any economists definition, and resisting Chinese mercantilism would strike a blow for free trade.

Yet, Henry Paulson in his first speech as Treasury Secretary on August 1 called for a strong dollar, and cautioned I am very concerned about the anti-trade rhetoric I hear coming from some quarters.

Scolding businesses and workers victimized by Chinese protectionism is not going to get China to revalue the yuan. Nor will lecturing China, as he did in interviews, that revaluing the yuan would be a huge benefit for China because China right now has an economy that appears to be overheating.

China may be growing at more than 10 percent a year but Chinese inflation is less than 2 percent. With inflation so low, China is not going to listen to Henry Paulson's prescriptions.

Treasury Secretary Henry Paulson urgently needs new tools to persuade China to significantly revalue the yuan, but President Bush will not give those to him.

For example, the Bush Administration opposes a bipartisan bill sponsored by Congressmen Duncan Hunter (R-CA) and Tim Ryan (D-OH) that would add the subsidies provided by currency manipulation to the list of protectionist trade practices actionable under U.S. trade law. It would permit domestic manufacturers to petition the Department of Commerce and U.S. International Trade Commission for duties on Chinese imports to offset these subsidies.

This law would be consistent with World Trade Organization rules that prohibit export subsidies. It would not be protectionism; rather, it would permit measures to offset Chinese subsidies and protectionism.

President Bush's reluctance to respond to Chinas currency manipulation encourages large U.S. multinationals, such as Caterpillar, GE and GM, to move production there. Similarly, large retailers like Wal-Mart, Target and Staples pad their profits with subsidized Chinese imports.

Profiting from Chinese protectionism, these companies systematically oppose strong action by Washington to combat it. They have become Beijing's most effective lobbyist in Washington.

Secretary Paulson, a former investment banker, seems quite comfortable with these arrangements.

Peter Morici is a professor at the University of Maryland School of Business and former Chief Economist at the U.S. International Trade Commission.