Should the US at last declare China a “ currency manipulator”? The administration was due to respond to this vexed question by April 15. Pressure to find positively has been building. Now it has wisely postponed a decision.

That China intervenes on a massive scale, to keep its currency down against the dollar, is unquestionable. At the end of 2009, its currency reserves had reached $2,400bn, or close to half of gross domestic product. The question, however, is how big a distortion such intervention has created.

Estimates of the degree of undervaluation vary massively. If, for example, the Chinese government allowed its citizens to invest abroad, the flood of capital might push the renminbi down, at least temporarily. Yet, despite the difficulties in defining and measuring degrees of undervaluation, the scale of the intervention, combined with efforts made to manage its monetary effects, makes it plausible that the renminbi is indeed undervalued, in real terms.

What is not so clear, however, is how much difference any undervaluation has made to China’s surpluses. Given the country’s flexible prices and high savings, movements in the nominal exchange rate might have only modest effects on external balances. Without alterations in consumption and saving, currency appreciation might create deflation, instead.

Yet, whatever the impact in the past, the decision to freeze the upward movement in the exchange rate in the summer of 2008 looks ill-timed. Since October 2008, China’s trade-weighted real exchange rate has depreciated by 8 per cent, even though the rest of the world has been struggling economically and China has been enjoying robust growth.

Yet defenders of China note that the trade and current account surpluses have declined sharply, while domestic demand has soared. From a peak of 11 per cent of GDP in 2007, the current account surplus declined to “only” 6 per cent in 2009. The problem with this argument is not only that surpluses are still enormous, but that the policies adopted to expand domestic demand, during the crisis, look unsustainable: year-on-year growth in credit was 27 per cent in February 2010. In 2009, real fixed investment rose at an obviously excessive rate of 18 per cent. When the new capacity comes on stream and domestic demand starts to slow, the external surpluses might explode upwards .

All this proves that China’s external balances and exchange rate are important issues for the entire world: China is too big to frame its policies without taking their global impact into account. But they are also big issues for China itself. While some insurance has made sense, the current level of reserves cannot do so. The investment of more than $1,800 per head in low-yielding foreign assets is a spectacular waste of resources. It should not be impossible to persuade the Chinese that higher levels of domestic consumption and less lending to irresponsible foreigners make sense.

This, then, is unquestionably an issue for frank and intense discussion. Fortunately, that is what is under way, in both multilateral and bilateral forums. So the US administration, at the highest level, should say something like the following to the Chinese government in the coming days.

“We are not going to make a finding against your currency policy, not because we do not believe we have a case, but because you have made a big effort to expand demand and reduce your surpluses since the crisis began. We appreciate this highly. We are also engaged in what we believe to be a serious dialogue on global adjustment, under the auspices of the Group of 20. Moreover, we expect the appreciation of the renminbi against the dollar to restart soon.

“Furthermore, we also trust that you see the domestic benefits in halting your currency interventions and rebalancing your economy. We understand this will take time. We can give you such time, so long as we share an understanding of the destination that will be reached. We are not going back to the wild party of the years before 2007. You must not build your future on hopes that we might. That way would lie disaster.”

So, indeed, it would, Former high-deficit countries, such as the US, need much lower current account deficits if their economies are to recover vigorously. If China were to seek to return to the massive surpluses of its past, a collision would be inevitable. But such a collision is not inevitable. Far from it. The journey towards rebalancing has apparently started. It is vital to ensure that it continues successfully in the years ahead.

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