As a measure of the difficulty of the task, one need only reflect on how little John Snow achieved on this issue during his three year tenure at Treasury. Despite much time and effort, John Snow managed to get the Chinese to appreciate by a meager 3 percent at a time when most analysts believe that the Chinese currency is undervalued by anywhere from 15 to 25 percent.

Last month, in a remarkable act of self-restraint, the US Treasury refrained from labeling China a currency manipulator despite all the evidence to the contrary. By so doing, the US Administration appears to have forestalled, at least for the moment, the mounting protectionist pressures in the US Congress to take punitive action against China for its foot dragging on the currency issue.

 The jury remains very much out, however, whether China will soon reward the US for its forbearance by being more flexible in the management of its currency. It also remains far from clear, whether Hank Paulson will be as successful as was John Snow in keeping Congressional protectionist pressures against China in check. Indeed, the likelihood that protectionist pressures will resurface later in the year would appear to be especially strong should the US economy slow down and should the US dollar continue to weaken. 

The increased scrutiny to which China’s exchange rate policy is being subjected would appear to be fully justified by China’s ever larger responsibility for today’s global payment imbalances. During 2005, China’s overall current account surplus rose to US$160 billion, or 7 percent of GDP, in 2006. This now puts China’s current account surplus on a similar footing to that of Japan, which until now has had the world’s largest current account surplus.

In response to international pressure, on July 21, 2005 China did revalue its currency by 2.1 percent. This followed an eight year period during which China had maintained a fixed exchange rate peg against the dollar. At the same time that it revalued its currency, China pledged that it would be more flexible in its exchange rate policy management and that it would look to a basket of currencies in setting its exchange rate. However, in the 10 months since revaluing its currency China has only allowed its currency to appreciate further by a paltry 1 percentage point against the dollar.

Currently there are two very disturbing aspects about the way China is managing its exchange rate. The first is that China is presently again virtually pegging its currency to the US dollar at the very time that the US dollar has resumed its descent in the international currency markets. This means that China is now having the gall to allow its currency to depreciate on an average or an “effective” basis at the very time that it is running larger and larger current account surpluses.

The second aspect that is disturbing is the very scale of the Chinese central bank’s intervention to prevent its currency from appreciating. At present, the central bank of China continues to buy dollars at the staggering rate of US$200 billion a year. As a result, by the end of March 2006, China’s international reserves had risen to US$875 billion or to almost as much as three times the size of China’s external debt.

While in its latest six-monthly foreign exchange report the US Treasury chose  to turn a blind eye to China’s massive foreign exchange intervention, the Treasury left little doubt about its displeasure with China’s handling of its currency. Indeed, the Treasury has characterized China’s advances on the currency issue as being “far too slow and hesitant given China’s own needs and its responsibilities to the international financial system”.

In the month since the US Treasury released its currency report, China has maintained its currency practically pegged to the dollar. This has to call into serious question the wishful thinking of some commentators that China would move decisively on the currency issue when it was not being subjected to undue foreign governmental pressure. It also has to call in question the notion that a new Treasury Secretary with greater background on China will make a difference. Rather, it would seem more likely that China will not budge from its long-maintained policy of deliberately keeping the currency weak as the means to promote export growth in order to generate jobs for China’s large surplus of rural workers.

The real test for US-China economic relations will come later this year as the US economy slows and as the US dollar weakens in the wake of the leveling off in US house prices. Should China not allow for a significant appreciation in its currency in those circumstances, one has to expect protectionist pressures in the US Congress to resurface with a vengeance.

One has to hope that China does not underestimate the potential for the US Congress to hue a protectionist line that would be severely damaging to the Chinese economy in spite of the US Administration’s efforts to the contrary and in spite of a Treasury Secretary who might be more sympathetic than was his predecessor to China’s economic aspirations. However, judging by China’s relative inaction on the currency issue since July 21, 2005, it might be too much to hope that a slow moving train wreck will be avoided.

Desmond Lachman is a resident fellow at AEI.