EU pressuring China to strengthen its currency

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The EU is expected to put pressure on China in a bilateral summit this week to allow its currency to strengthen more quickly, says the BBC here. Luxembourg’s prime minister, Mr Juncker, has claimed that the yuan is undervalued by 20-25%, leading to a soaring trade deficit between China and the EU which rose by 25% in the first eight months of the year to £50.23bn.

China has also come under considerable pressure from the US over recent years to strengthen the yuan due to the large bilateral trade imbalance between the two. Official US government figures showed a bilateral trade deficit with China in 2005 of $202 billion, although these figures are somewhat exaggerated by certain quirks of the US method of measuring trade flows with China. The US has criticised China’s tight control of its exchange rate and pushed them to float the yuan.

Ironically , floating the yuan is likely to worsen the problem (if it is a problem) rather than improve it. As UNCTAD’s 2007 Trade and Development Report argues (pages 13-29), floating its currency would open up opportunities for ‘carry trade’ – that is, the practice increasingly employed by investment funds to borrow money in local currency from a country with low interest rates, and then convert it into another currency (often US dollars) that earn a higher yield. That is, borrow money at low interest rates (China’s current real interest rate is negative) and lend the money in a different currency where it earns high interest rates. As UNCTAD say (page 28), ‘if China were to give in to the pressure from the United States and float its exchange rate, [the yuan] might risk following the examples of the yen and the Swiss franc and be carried to high interest rate locations. If that were to happen, it would depreciate and cause a further increase in China’s competitiveness instead of reducing it. Such an outcome would clearly worsen the global imbalances’.

China, as we all know, is currently growing at around 10% a year by steadfastly ignoring the advice it receives from what Ha Joon Chang has termed the Bad Samaritans (i.e. Western governments) and has lifted millions of people out of poverty by doing so. It would be a shame if that process were halted by increased instability resulting from China giving in to badly thought out recommendations for floating their currency from countries that not long ago managed to precipitate a financial meltdown across Asia with their advice for capital account liberalisation.

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