August 19, 2005 | Page 4

DAVID WHITEHOUSE explains the implications of the Chinese government's decision to allow the value of its currency--the yuan--to rise against the dollar.

WHEN U.S. officials learned in July that China would allow the value of the yuan to rise, they claimed that years of diplomatic pressure were finally paying off.

A stronger yuan (more commonly known as the renminbi when it's exchanged internationally)--and a correspondingly weaker dollar--will cut the trade imbalance between the two countries, which ran in China's favor last year by $160 billion. China accounted for more than a quarter of the total U.S. trade deficit last year.

But outside pressure had little to do with the Chinese decision. Last month's revaluation will allow China to fend off some U.S. charges of unfair trade. But the Chinese government was really thinking about how manage its economy better--the same reason that motivated it to peg the renminbi to the dollar in the first place in 1994.

Fixing the value of the renminbi helped to fuel China's growth in several ways. For one thing, the fixed, cheap renminbi allowed a massive growth of exports to foreign markets such as Japan and the United States. For another, the fixed rate shielded China from rapid devaluations that overtook Asian currencies in the crisis of 1997-98.

Nevertheless, the focus on exports has twisted the Chinese economy in ways that the country's elite would now like to correct. Economic growth has averaged about 9 percent each year for 25 years, but social inequality has also grown as living standards for workers and peasants failed to keep pace with profits.

Bosses want to keep wages low, of course, in order to produce the cheapest exports possible--and the ruling Communist Party has obliged by maintaining a high level of repression. But the focus on exports has also led to a neglect of production for domestic consumption. What's more, China is now flooded with dollars--through the sales of goods to U.S. buyers and through U.S. corporate investments in China--a trend that has pushed up local consumer prices.

The Chinese regime is hoping that strengthening the renminbi against the dollar can cool off the rate of exports, shift investment toward domestic consumer goods and keep prices low. In theory, the regime could thus afford to make greater concessions to demands for improved living standards.

These demands are getting more insistent. Millions of workers and peasants have joined in a new wave of strikes, demonstrations and riots. The government reports 74,000 mass protests last year, up from about 10,000 a decade ago.

The breakneck pace of growth has created other imbalances in the economy, leading to supply bottlenecks, including recurring energy shortages. As speculation pushed investment forward, many sectors built up excess productive capacity, the prices of raw materials have shot up, and banks continue to carry huge burdens of bad loans.

The threat of a crash is real, so the regime is looking for ways to create an economic "soft landing"--which would slow economic growth without bringing it to a halt.

Currency revaluation is only part of the strategy. China now holds a $700 billion reserve in foreign currency--including $230 billion in U.S. Treasury bonds. China's leaders wish to diversify this "overseas portfolio" through direct foreign investments.

The attempted purchase of the U.S. oil company Unocal--which was held up by Congress in late June for "national security" reasons--is part of a wider strategy of direct investment that ranges from Iran, Russia and Pakistan to Africa and Latin America. China is seeking to secure access to energy and raw materials for its future growth, but the "liberalized" investment regime is also calculated to siphon off the current bulge of U.S. dollars in Chinese banks that is pushing up inflation.

Since China's rulers see revaluation as a way to manage their own economy, they aren't letting the renminbi "float" free of all restrictions against foreign currencies. The first revaluation is only 2 percent against the dollar, and Frank Gong, a JPMorgan Chase analyst, predicts a rise of no more than 10 percent in the first year. Estimates of the "real" value of the imbalance between the two currencies range from 30 to 50 percent--and as commentators on PBS NewsHour pointed out, gains in Chinese labor productivity widen the gap by 5 percent a year.

There is a danger that speculators will rush to buy renminbi in anticipation of its future rise--thus pushing up its effective price so fast that major economic dislocations occur. But the biggest danger for the regime is that its currency manipulations simply won't work to address China's fundamental economic problems--overstretched banks, industrial overcapacity and a growth strategy that's based on keeping Chinese workers repressed and underpaid.

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