American jobs vs. China's currency: Is the yuan too high?

Washington agreed to postpone releasing a report that would have labeled China a currency manipulator. On Monday, Chinese Premier Hu Jintao and President Obama spent little time discussing this source of ongoing tension in US-China relations. Many analysts suspect that China will soon quietly adjust the value of its currency, the yuan.

Here's a short Q&A on this complex issue:

How does the value of China's currency affect the average American?

The value of China's currency, the yuan or renminbi, affects the price of Chinese-made goods sold in the United States by retail stores such as Wal-Mart.

A cheap yuan makes Chinese products cheaper in the US. A stronger yuan would make TVs, computers, and other things made in China more expensive for American consumers.

Goods from China now make up nearly 20 percent of America's imports. In 2009, top imports from China included electrical equipment, apparel, toys and games, and furniture.

But US manufacturers are hurt by a cheap yuan. They say Chinese goods are sold at a sharp "discount" in the US. For example, a Chinese-made chair should sell for $100 in the US if the yuan was fairly valued, but now sells for $75, they say – undercutting American competitors, and thereby costing American jobs.

Is China's yuan really undervalued?

Most economists say, "yes." As evidence, they point to China's massive foreign-exchange reserves and its huge trade surplus.

The rapid growth in China's foreign-exchange reserves means China's central bank has bought huge numbers of US Treasury notes and other foreign currencies to keep down the value of the yuan. Last year alone China's foreign reserves increased by $450 billion, to total $2.4 trillion.

China's trade surplus means it's selling the world far more stuff than it's buying. Some observers look at that growing gap and infer that Chinese goods are too cheap abroad – and therefore, that the yuan is also too cheap.

The International Monetary Fund has also said that China's yuan is undervalued.

But a few prominent economists dispute this notion. They include Goldman Sachs's chief economist, Jim O'Neill, and Shanghai-based independent economist, Andy Xie. Mr. Xie says it's wrong to conclude from China's trade surplus that the yuan is undervalued. And he says China's yuan may even be overvalued due to speculative "hot money" that's fueling a property bubble in China and putting sharp upward pressure on its currency.

"China is in a huge mania," says Xie. "The No. 1 issue isn't the exchange rate, it's financial mania."

But don't market forces determine currency value?

China's currency markets are not free or completely open. China's central bank intervenes in its currency market to control the value of the yuan.

Here's how it works: Chinese exporters accumulate US dollars or other currencies from foreign customers. However, they need to pay their Chinese employees and suppliers in yuan.

Chinese exporters go to China's currency market to swap their dollars for yuan. With thousands of firms doing this, the demand for yuan is high. In a free currency market, this would push up the price of the yuan as demand outpaces supply.

To prevent that from happening, China's central bank increases the market supply of yuan. It sells as many extra yuan as the market wants, targeting a rate of around 6.83 to the US dollar. "It's a massive operation," says Nicholas Lardy, a top expert on China's economy at the Peterson Institute for International Economics in Washington, D.C. "For a big economy like China's, the scale of intervention in the market is without precedent in global history."

Why is China keeping its currency undervalued?

The short answer is that it keeps Chinese exports cheap. That helps Chinese firms make money and keeps China's export-driven factories humming. A cheap yuan also means political stability in a nation where tens of millions of Chinese peasants need jobs.

Economists say China didn't necessarily set out with the goal of a cheap yuan. In the late 1990s, the yuan was pegged to the US dollar at about 8.28 to 1. No one complained then, Mr. Lardy says, because the US dollar was strengthening.

The problems started around 2001, he says, when the US dollar weakened and took the yuan with it. The US and other trading partners watched with concern as China's trade surplus grew and its foreign-exchange reserves ballooned.

By that time, a powerful interest group had formed in China in support of a cheap yuan. This group included big exporters and politicians in China's coastal provinces, Lardy says. China's currency policy fueled export sales, and kept the money rolling in and the economy booming in those regions.

The US has been pushing China to revalue the yuan for years. When might China change its policy?

China has already changed its currency policy once before. In 2005, after a few years of pressure, it allowed the yuan to begin appreciating slowly. (Policy wonks call this a "managed float" policy.) From then until 2008, the yuan quietly gained more than 20 percent against the dollar.

China stopped doing this when the global economic downturn hit. It returned to a de facto peg to the US dollar. It did this to protect its exporters and ensure economic stability amid tough global conditions.

Now, economists say Beijing is waiting for clearer signs of a strong global recovery before going back to the "managed float" policy.

Lardy expects that China may begin allowing the yuan to appreciate against the dollar "in the next few weeks," and that we could see a 4 to 6 percent appreciation against the dollar by the end of the year.

"There are a lot of good domestic reasons for China to allow the renminbi to appreciate," says Lardy, including fighting inflation and helping create more service-sector jobs.

Xie also thinks Beijing may allow the yuan to appreciate this year, but only by a small amount. "China will not be able to make a change big enough to make Americans happy – it's impossible," Xie says.