The Chinese premier Wen Jiabao is fed up with the pressure for currency revaluation. It would be, he warned Europeans, a disaster for many export companies in China that would send workers back to their villages.
"If China saw social and economic turbulence, then it would be a disaster for the world," he added. But China is not the only nation rigging its currency values. Other nations including Switzerland, South Korea, Japan and Taiwan are also managing currencies, attempting to make them weaker and their products competitive. As the world's largest exporter with a massive and growing surplus, China is under the spotlight and may have to swallow the bitter pill - one that would perhaps be sweetened if China could persuade its Asian manufacturing partners to adopt a regional currency accord.
Mr Wen is trying to manage demands from the US and Europe to allow the renminbi to strengthen and reduce China's large, growing trade surplus. This surplus was annoying when the world economy was strong, but cheap exports kept prices low. Now, with deflation and unemployment as threats, China's currency management is seen by other nations as predatory and destabilising.
The US position is that keeping the Chinese currency undervalued - by buying dollar-based assets with Chinese currency - will create dangerous bubbles in China. Indeed, there is massive overcapacity in housing, with one Chinese electric company reporting 60 million housing units connected and not using any electricity, so presumably empty.
If another 20 to 30 million units under construction are added, China's excess capacity could house the entire US population. Excess capacity in many commodities such as steel and even infrastructure add to the argument's strength. China will find it very tricky to switch from exports to domestic consumption if there's little need for housing or industrial expansion. It may be that a real slowdown is simply unavoidable in the next few years.
More than a quarter-century ago, Japan played the role that China does now, with its auto and electronics exports. The US trade balance was in a bad position, due in part to high fiscal deficits, when it negotiated the "Plaza Accord" in late 1985. The current account deficit, largely the trade deficit, was nearly 3 per cent of GDP that year, and so a managed strengthening of Japanese and European currencies was negotiated. This currency change shifted manufacturing to other parts of Asia.
It's true that the trade balance with Japan did not improve much, but overall the dollar devaluation succeeded in lowering the deficit. This experience gives many in the Congress fuel for believing that if China would "play fair", then the US trade deficit would shrink again.
Critics point out, correctly, that in the event of a Chinese currency adjustment, most of the jobs "lost" to exports from China would not return to the US, but simply move to other Asian or perhaps Latin American nations. However, many of the other exporters would buy more from the US than China does, so there might be a net gain. China's fear is that their lost exports would simply move to other low-income exporters, leaving China with millions unemployed. If China had a recession, the reduced demand for raw materials would hit many nations that now benefit from China's voracious demand and might also further slow sluggish rich-nation economies. While this is well short of a global crisis, it would be difficult for China and an unwelcome negative shock for the rest of the world.
The basic problem is that large, and certainly growing, trade surpluses chalked up by China cannot continue. The political pressures alone means that there has to be some meaningful move towards adjustment - and the limits of monetary and fiscal expansionism in the OECD countries mean that their economies cannot keep on spending on imports with high levels of unemployment. China has painted itself into a corner.
One line of argument, which is correct, may be too subtle. With a shrinking labour force and strong export growth, China's real exchange rate - the "headline" or nominal rate adjusted for inflation differences - is actually adjusting exactly like US critics demand. Mr Wen is correct when he says that thousands of factories have thin margins and cannot absorb a 20 per cent nominal appreciation. What if they must pay 30 per cent higher wages? China may already be adjusting, but the effects will take another year or two to appear.
Another approach might help China, but be less attractive for its neighbours. Many higher-end exports of China compete with those of Taiwan, South Korea and Japan. If those nations could negotiate an Asian Plaza Accord and set their exchange rates relative to one another in some agreeable range, the pain and danger of China adjusting alone would be less. This might allow more nominal exchange-rate flexibility with fewer sales lost to its higher-end competitors. It would basically be an agreement among major Asian exporters to share the global adjustment and not take advantage of any Chinese currency strengthening.
Unfortunately, the political atmospherics are increasingly strident on both sides. China could, of course, retaliate against any US tariff on its exports. But by US count, China's exports to the US last year were four times US exports to China. It's clear that in a protectionist battle, the larger importer holds better cards. It's even possible that the US and EU would cooperate so that one couldn't be picked off alone in a trade war. The Chinese currency has appreciated slightly against the dollar since June, but actually depreciated against the euro.
With the EU not far from a banking crisis, it's also sensitive to growing Chinese exports. In that case, China could maintain its exchange rate and face joint tariffs or agree to some adjustment and try using fiscal policy to offset the reduction in its trade surplus. The latter would be better all around, but does not seem likely.
David Dapice is associate professor of economics at Tufts University and the economist of the Vietnam Programme at Harvard University's Kennedy School of Government
© Yale Global 2010