Mainland China faces a currency bind. The yuan is almost certainly below its fair market value against the US dollar. If China's trade surplus with the US continues to expand, the central government will face intense political pressure from the US to revalue the yuan upward - especially next year, a presidential election year, when candidates will be scrambling for votes in key US manufacturing states which believe they have lost jobs to 'unfairly cheap' Chinese imports.
But if China allows an upward revaluation, it risks a return to the deflation it has so recently escaped. We continue to be sceptical about those who claim to know the 'true' value of the yuan, but a simple calculation suggests it must be worth more than 8.3 to the US dollar.
Last year, China ran a current account surplus of about 3 per cent of gross domestic product (GDP) - its ninth consecutive surplus. Meanwhile the US, a chronic current account deficit country, saw its deficit soar to around 5 per cent of GDP. In a perfectly predictable response to this ballooning deficit - which reflects, by the way, not competition from 'cheap Chinese imports' but the fiscal profligacy of the Bush administration - the value of the dollar has fallen by about a quarter against the currencies of its major trading partners over the past 15 months.
After nine straight years of healthy current account surpluses, China's currency ought to be worth a bit more than it was in 1995. But because of its peg against a US dollar now in free-fall, it is worth exactly the same against the dollar, and a good deal less against other major currencies.
China ran a trade deficit in the first quarter, and may run a small current account deficit this year, but this is irrelevant so long as the US deficit gallops ahead. Moreover, capital continues to pour into China, putting additional upward pressure on the yuan. In the first quarter, China's foreign exchange reserves soared by US$30 billion, despite a US$1 billion trade deficit. So, what is wrong with having an undervalued currency? Chinese are investing every spare penny they have at home - even bringing back illegal money they had previously stashed overseas - because the yuan is undervalued, there are tight controls on investing yuan abroad, and investment returns outside China are poor anyway right now. This cash is inflating a huge investment bubble. The pop could dwarf the 1997 Asian crisis, creating deflation, a massive increase in bad loans and a loss of confidence.
The problem for policy-makers in Beijing is that the obvious cure - a gradual revaluation, probably by widening the trading band around the 8.3 reference rate, paired with a relaxation of controls on outbound capital - will also create deflation. So far the central government has resisted a revaluation, in part because deflation would increase the value of the non-performing loans on the books of the state banks, which it is desperate to reduce. So that is the choice: a little deflation now, or a lot later.