Foreign Exchange Market

China in danger of losing gold medal for competitiveness

PUBLISHED : Tuesday, 17 July, 2012, 12:00am
UPDATED : Tuesday, 17 July, 2012, 12:00am


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The 2012 Olympic Games aren't due to begin for another 10 days, but China has already taken the gold medal for competitiveness.

When the athletes of Team US march into London's new Olympic stadium for the opening ceremony next Friday, they will be wearing uniforms made, not in America, but in China.

Forget for a moment that the high-value element of these costumes - their design - was contributed by an American company, Ralph Lauren. Only the low-value process of actually stitching them together was done in China.

Even so, the news that American athletes would be representing their country wearing Chinese-made uniforms ignited a political firestorm in the United States.

Mindful of November's general election, politicians from both main parties have thrown themselves into an orgy of China-bashing.

In recent weeks, US President Barack Obama's campaign team has slammed Republican candidate Mitt Romney for profiting from investments in companies that outsourced American jobs to China.

Meanwhile Romney, for his part, has accused Obama of being soft on Chinese trade malpractices. He has pledged that on his first day in office he will declare China a currency manipulator, opening the way for retaliatory sanctions against Beijing.

Such fighting talk during a presidential campaign is nothing new. Charges that China is destroying American jobs by artificially undervaluing its exchange rate in order to steal an unfair trade advantage play well with a US electorate daunted by 8 per cent unemployment.

But although Beijing clearly does manipulate the yuan's exchange rate, it is far from clear that China's currency is as undervalued as American politicians believe, or that Chinese companies enjoy a considerable competitive advantage as a result.

As no less an authority than US Treasury Secretary Tim Geithner has pointed out, countries that undervalue their currencies tend to suffer high domestic inflation, which results in an effective appreciation whether they like it or not.

This phenomenon in reverse is familiar to Hongkongers. In the late 1990s, the Hong Kong dollar became badly overvalued, denting the city's competitiveness. With the currency prevented from appreciating by its peg to the US dollar, the city underwent years of wrenching deflation that eventually restored its real effective exchange rate to a competitive level (see the first chart).

As Geithner noted last year, the opposite has been happening in mainland China. The yuan was undervalued, and as a result the mainland experienced a nasty bout of inflation between 2010 and 2011, with the official rate of consumer price rises hitting a high of 6.5 per cent last summer.

As result, the yuan's real effective exchange rate shot up more than 12 per cent over 2010 and 2011, even though Beijing restricted the currency's nominal appreciation to just 6 per cent over the same period.

Now, however, there are signs that the yuan's rapid real appreciation may have eliminated much, if not all, of the currency's undervaluation.

In recent months the authorities have stopped steering the yuan gradually higher in the foreign exchange market. So far this year, the currency is actually down against the US dollar by 1 per cent.

Yet despite that, China's rate of consumer inflation has collapsed to just 2.2 per cent. In real effective terms, the yuan has been flat this year, and some analysts believe the economy is in imminent danger of slipping into deflation.

That's powerful evidence that the yuan is now trading somewhere close to its fair value. If it is, it means that much of China's cost advantage has been eliminated.

That shouldn't be too surprising. Between 2010 and 2011 China's manufacturing wages shot up by almost a third, far faster than productivity gains. As a result, unit labour costs rose an estimated 20 per cent over the two-year period.

As a result, Chinese manufacturing competitiveness was severely eroded, especially compared with the US, where labour costs were static.

So although China may have taken gold for competitiveness ahead of this year's Olympics, it may find itself struggling to retain its place on the podium in Rio de Janeiro in four years' time.