Fixing the yuan

Smart people have started noticing that the feel-good story of China helping lift the world out of recession also doubles as a more troubling story of China expanding its dominance of global trade. And they have started by pointing fingers at China's currency, which appears undervalued by virtue of being fixed to the weak U.S. dollar, making China's exports cheaper than they otherwise would be.

That means a year of bombastic rhetoric is ahead, because after experts as influential as Paul Krugman pick up on things like this in the New York Times, non-experts (whether they're elected or just have a cable show) are sure to follow in spades. Unless Chinese policymakers do something soon to appreciate the yuan, the chances of a full-fledged trade war will increase dramatically this year, not only with the U.S., but also with the rest of the world.

Why should China care what the rest of the world thinks? Because the world is primed for some old-fashioned China bashing, which will translate into trade barriers for Chinese products. That, in turn, will ratchet up Chinese nationalist (sorry, I mean "patriotic") pressures not to concede any economic point to the foreign devils.

This bind will only get worse as the U.S. trade deficit with China, which declined in 2009, increases again as expected in 2010. The U.S.-China relationship has deepened in complexity over the years, allowing the two nations to smooth over skirmishes like the tire tariffs imposed by the Obama administration last year. But the number and intensity of trade cases will escalate this year, and that relationship will become tougher to manage.

Domestic politics in the U.S. and other countries will make matters worse. With the jobless "recovery" in the U.S., you can bet on a return of "your-jobs-are-being-sent-to-China" demagoguery in this year's congressional campaigns. In truth, and no less problematic, the number of American jobs being lost to China almost certainly pales in comparison to the job losses in other countries competing with China for the American consumer market.

Although China's exporters continued to struggle in 2009, they still fared much better than the rest of the world, increasing their share of U.S. imports to nearly 20 per cent, and their proportion of global exports to nearly 10 per cent, topping Germany for the No. 1 spot. As The Economist notes, that puts China on par with Japan's global peak of 10 per centin 1986, before rapid appreciation of the Japanese yen helped erode its export dominance.

Since the financial crisis dawned and China's exports plummeted, Chinese policymakers have fixed its currency's value at about 6.83 yuan per U.S. dollar, which means that as the dollar has declined in value, so has the yuan against much of the world's currencies. This is, as Krugman argues, a mercantilist policy that has propped up China's exporters, and in a fair world China would agree to appreciate its currency.

Chinese leaders understandably view things quite differently. Premier Wen Jiabao has repeatedly made clear that China's economic rebound is not yet clearly sustainable and stable. Intent on staying in power, Wen and the rest of the Chinese leadership are as worried about creating jobs as any elected leader in the West.

Perhaps substantially more worried. China has many cities with economies highly dependent on exports that are now surviving on thin margins. An appreciation of the yuan may well be wise economic policy for China in the long run, and some Chinese economists are advocating exactly such a move. But in the short run a stronger yuan might wipe out those exporters' profit margins and, with them, millions of jobs. That is a nightmare for the Communist Party that looks worse than the prospect of a trade war.

Gady Epstein is Beijing bureau chief for Forbes.