Paul Krugman echoed the sentiment expressed by Simon Johnson in arguing that the U.S. needs to quit pussyfooting around and finally label China a currency manipulator (see Taking on China).

Tensions are rising over Chinese economic policy, and rightly so: China’s policy of keeping its currency, the renminbi, undervalued has become a significant drag on global economic recovery. Something must be done.

Today, China is adding more than $30 billion a month to its $2.4 trillion hoard of reserves. The International Monetary Fund expects China to have a 2010 current surplus of more than $450 billion — 10 times the 2003 figure. This is the most distortionary exchange rate policy any major nation has ever followed.

And it’s a policy that seriously damages the rest of the world. Most of the world’s large economies are stuck in a liquidity trap — deeply depressed, but unable to generate a recovery by cutting interest rates because the relevant rates are already near zero. China, by engineering an unwarranted trade surplus, is in effect imposing an anti-stimulus on these economies, which they can’t offset.

So how should we respond? First of all, the U.S. Treasury Department must stop fudging and obfuscating.

Twice a year, by law, Treasury must issue a report identifying nations that “manipulate the rate of exchange between their currency and the United States dollar for purposes of preventing effective balance of payments adjustments or gaining unfair competitive advantage in international trade.” The law’s intent is clear: the report should be a factual determination, not a policy statement. In practice, however, Treasury has been both unwilling to take action on the renminbi and unwilling to do what the law requires, namely explain to Congress why it isn’t taking action. Instead, it has spent the past six or seven years pretending not to see the obvious.

I agree with Krugman and with Johnson (see China and the Revaluation of the Yuan) that labeling China a currency manipulator is likely without repercussion. There is little that China can do but continue to purchase dollar-denominated assets. Dumping its dollar-denominated holdings seems far-fetched, and runs counter to its own self interest.

That said however, and as I’ve argued on this blog before, we must be careful what we wish for when it comes to a yuan revaluation.

Think about the short-term shock to the Chinese economy, which depends upon exports for a good portion of its GDP. By many accounts, exports make up some 25% of Chinese GDP. A revaluation of the yuan makes Chinese exports relatively more expensive thereby decreasing foreign demand for Chinese-made goods. This negatively impacts local production and creates a feedback loop through to domestic employment and wages. In the extreme, this threatens social stability, and China is certainly not the poster-child for social stability.

Not only that, but given the foreign interests and investments in China, it is not entirely clear to me that a yuan revaluation that catapults China into recession would not result in a global contagion effect. Supply chains are so interconnected around the globe that an upward price movement for intermediate and finished goods coming out of China could have dire consequences for Western companies that rely on Chinese-sourced goods (just ask Wal*Mart).

I certainly agree that it is in the long-term interests of the U.S. for China to address its imbalances via some kind of yuan remediation. It is also in China’s best interest. However, the near term economic adjustments associated with a significant rise in the value of the yuan could be painful, not just for China, but for the rest of the world as well. In addition, a sudden rise of the Yuan could be socially destabilizing for China. Given China’s already tenuous political and social situation, it is therefore difficult from a policy standpoint for Chinese politicians to justify decisions that might not be in their own near-term interests (and swallow the pill so to speak), …even though they recognize the problem.

But I agree that it likely won’t hurt to call China out.

Nevertheless, when China does finally revalue their currency, my recommendation is that it proceed with caution. A gradual revaluation to competitive levels over a number of years is probably the best outcome for the global economy.

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