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President Barack Obama's newly appointed Treasury Secretary, Tim Geithner, accused China of manipulating its currency and has pledged aggressive diplomatic actions to force China into change.

President Barack Obama’s newly appointed Treasury Secretary, Tim Geithner, accused China of manipulating its currency and has pledged aggressive diplomatic actions to force China into change.

This is hardly the first time China has been in the forefront of the news regarding the value of its currency and its exchange rate regimes. Yet in the past, the US has been reluctant to fully accuse China of currency manipulation. Instead, the Bush administration and then Treasury Secretary, Henry Paulson, did not push for major changes and instead focused on long term political issues.

Until 2005, the renminbi was pegged to the US dollar. This is common for many developing countries because it helps to stabilize their currency. In 2005, when China began to open up, they removed the peg for a managed float, allowing for more control.

Since the abandonment of the fixed peg, the renminbi has appreciated about 20 percent against the dollar. However, many in the US and EU believe that there has not been enough of an appreciation.

Because of their artificially low currency, it is argued that China has an unfair advantage in their purchasing power. One way to show this point is to look at purchasing power parity. The economic theory states that in an efficient market, identical goods should have equal price. If the goods are not equal, the exchange rates should be modified to compensate.

A common measurement of purchasing power parity is called the ‘Big Mac Index.’ This index compares the price of a McDonald’s Big Mac in each country, converted to a common currency through current exchange rates. In this index, it is easy to see whether a currency is overvalued or undervalued.

At the market exchange rate for January 19th, 2009, the price of a Big Mac in China was only $1.83 compared to $3.54 for America. One could argue, according to the purchasing power parity and the ‘Big Mac Index,’ that China’s currency is undervalued by almost 50%.

While not everyone fully believes in purchasing power parity because it does make a few impractical assumptions, many people assert that it can, at the very least, show a trend towards overvaluation or undervaluation of a currency.

Because of this undervaluation, it is much more profitable for China to export their goods than to import them. This has led to a massive trade surplus of $297.5 billion as of 2008. And because America is the largest trading parter with China, this had contributed to the large trade deficit that is currently plaguing the US. As of publication, the US trade deficit was at $42 billion.

Furthermore, due to China’s size and abundance of cheap labor, gaining a competitive advantage through exchange rate manipulation seems even more unfair. With such cheap imports coming from China, hundred of thousands of jobs have been lost because of the inability to match low production costs.

The fact that the Obama administration has come out publicly in the first few days of office, seems to be an early indication that some action will be taken. With such cheap goods flooding the market from China, one option that has been discussed is to raise the tariff rates for all imports from China.

Senators Schumer and Graham believe that a tariff of 27.5% would be necessary in order to quell the uneven trade flow. This suggests that the US believes China’s currency is undervalued by up to 27.5%.

However, the easiest solution, as far as US policymakers are concerned, would be for China to correct the problem themselves and appreciate the renminbi.

Source: www.AsiaEcon.org
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Source: www.asiaecon.org |

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