I always hear about the Chinese keeping their currency at an artificial rate to help exports. Where would the cost of doing that show up?

BY Paul Solman  January 23, 2008 at 11:46 AM EDT

Question/Comment: I always hear about the Chinese keeping their currency at an artificial rate to help exports, but I know from trying to hold a lid on a boiling pot that the pressure is going to come out somewhere. If and when a country does that to their currency, where would the cost of doing that show up? It can’t be free or everyone would do it.

Paul Solman: Right you are. Here’s what a pretty savvy guy wrote about this back in 2004: “Morgan Stanley’s chief Asia economist Andy Xie warned Wednesday that if the yuan is allowed to appreciate under international pressure, China could be caught in a trap of low growth, low interest rates and low inflation but a strong currency. The result could be an economic bubble such as the one seen in Japan, China Radio International reported Wednesday…. The Japanese yen was revalued in 1985, causing domestic companies to move out of the country and invest in Southeast Asian nations.The low-interest policy that followed ceated an economic bubble, with excessive investment in stocks and real estate. Japan is still working to recover from the bursting of the bubble in the early 1990s.”

Let me add that it took 360 Japanese yen to buy one dollar (and thus one dollar’s worth of stuff) back in 1971. Today, it takes only 113. All else equal (i.e., forget about inflation), that means American stuff is less than one-third the price, to a Japanese person, than it was 36 years ago.

And this should make clear the cost of maintaining an artificially low currency rate. The country’s citizens – those who import more than they export – pay the price. The more your currency is worth, the more you can buy abroad. The less it’s worth, the more expensive stuff becomes. This is the same effect inflation has. In fact, devalue your home currency and keep buying stuff from abroad, and that is inflation.

Martin Neil Baily, guest vetter: The Bretton Woods exchange rate system broke down in 1973 for good reason. If currency values get way out of line with the forces of supply and demand, something is going to give – it is like trying to keep the lid on a boiling pot, as Steve Wilson said. For China, there is a limit to the amount of dollar reserves they can pile up before they strain their own economy, notably by causing inflation. Any country that is piling up foreign currency reserves has to “sterilize” the impact on its own domestic money supply or else it will quickly face inflation. Eventually the required sterilization becomes bigger and bigger and harder to sustain. China’s surplus with the rest of the world (its “current account surplus”) is expected to reach 12 percent of its GDP in 2007 and to keep growing. This is huge, and is not on a sustainable path.

China wants to keep its exports growing partly because it is so scared of social unrest. As it transforms from a socialist economy to a market economy, there are huge adjustments to be made. Manufacturing employment in China declined by 15 million between 1995 and 2002, as state-owned enterprises contracted.

A sudden large appreciation of the yuan could trigger a downturn, but their economy is dynamic and competitive enough to absorb a gradual appreciation. This seems to be what they are doing now, although not fast enough. China is not yet ready for full convertibility and a market determined exchange rate, but they should be adjusting their currency peg more quickly. If they do not, they may trigger a protectionist backlash in the U.S. or in Europe.