Why the yuan won't dwarf the dollar

Much American fear these days swirls around China. Its military ambitions, the offshoring question, its huge export volume, and Chinese purchases of American assets come up frequently in political and financial strategy discussions. In particular, Chinese ownership of Treasury debt seems to speak to an ominous, if vague threat of outside control.

Yet if Americans are to assess their fears realistically, they will have to look beyond feelings of vulnerability and examine Chinese weaknesses, needs, and objectives. And in this context, it is apparent that China is no freer to act than America is. Given the economic, demographic, and political realities in today's China, there is every reason to expect that the present balance, precarious as it is, will stay securely in place for some time to come.

The key issue for China is one of demographics and jobs. The country's huge labor force puts a relentless pressure on Beijing to create jobs at a fantastic rate. According to Chinese government statistics, some 40 percent of China's workforce lives on the farm, overworked surely, but basically underutilized and certainly underpaid. Every month, some 1 million to 1.5 million of these rural workers walk off the farm and into the cities in search of work. With urban unemployment in China at near 10 percent, the social strain is tremendous. China must produce 1 million to 2 million jobs a month to stay ahead of this kind of pressure.

The only way China can create jobs at this pace is through exports in general and to the United States in particular. And the only way to promote exports fast enough is by keeping its currency, the yuan, cheap enough to the dollar to make Chinese goods attractive to American buyers. This export-oriented, cheap-yuan approach has dominated Chinese policy for decades now, since, in fact, the country began its market reforms in the late 1970s. And despite appearances, Beijing's decision last summer to remove the yuan from its decade-long peg to the US dollar did nothing to alter its commitment to this policy. The authorities hardly let the currency move at the time and clearly continue to manage it to keep it cheap to the dollar.

Of course, the cheap-yuan objective makes significant other demands on China. To manage the currency, the central bank of China, the People's Bank, must go into foreign exchange markets continually and buy dollars. This was the case even when China maintained a rigid peg between its currency and the dollar, and it is true now that it has allowed some movement in the exchange rate. Without such action, American purchases of Chinese products would naturally tend to adjust the dollar down and the yuan up. Of course, these continual dollar purchases force still other financial arrangements on the People's Bank of China. Because the Bank cannot sell the dollars that they have purchased without undoing their cheap-yuan strategy, it has little option but to invest those dollars back in the United States, largely in US Treasury bonds. Effectively, by circling the funds back to the US in this way, China lends Americans the money with which to buy its exports.

Clearly, if China were to abandon this policy, it would go hard on both countries. The yuan would rise on foreign exchange markets and the dollar would fall. Chinese exports would suffer. American consumers would lose their access to cheap Chinese imports and accordingly see a decline in their standard of living. The absence of cheap imports would also likely prompt a generalized inflationary pressure in the US that would erode living standards further. With China no longer buying dollars and therefore no longer buying US bonds, American interest rates would rise, especially in the face of an added inflationary threat. This country would go into recession and probably China, too.

But while this disaster scenario is a familiar warning in the media and business strategy circles, it should be clear that it is far from probable. China's desperate need to make jobs locks Beijing into the current arrangements. Indeed, any change would invite social unrest and probably amount to political suicide. Before Beijing even considers a major change in its policy, it must either find another foreign buyer as large and as reliable as the US or build its domestic market sufficiently to replace American buying. Neither development is probable anytime soon or even feasible.

Understandable as America's sense of vulnerability is, fears of a sudden Chinese move are unreasonable. On the contrary, probabilities suggest that China will support the current order for some time to come.

Milton Ezrati is the senior economic strategist for Lord Abbett.

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