Why the Yuan Won't Be an Issue at the U.S. China Summit

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The United States rolled out the big guns for the second Strategic and Economic Dialogue (S&ED) with China since the Obama administration took office. The two-day talks began yesterday (Monday) with such luminaries as U.S. Treasury Secretary Timothy F. Geithner, Secretary of State Hillary Clinton, and Federal Reserve Chairman Ben S. Bernanke taking part in the Beijing summit.

The last Strategic and Economic Dialogue between the world's largest and third-largest economies was riddled with bickering over currencies and the placing of blame for the global recession. However, officials on both sides of the Pacific this time around have taken a more tempered approach in the hopes that more productive talks will emerge.

U.S. officials will undoubtedly make addressing the value of the yuan a priority, but if the meeting's cordial opening is any indication, they will do so humbly. That tactic would be well advised, considering the issue of currency valuation has been a major point of consternation between East and West.

The United States opinion of China's currency, the yuan, is that it is significantly undervalued. Beijing in mid-2008 pegged its currency to the dollar at a value of about 6.83, making its exports significantly cheaper to the benefit of China's manufacturing sector. But now that China's economy has embarked on a full-blown recovery – nearly to the point that it is overheating – the peg seems excessive.

Tensions over the yuan came to a boil earlier this year. A series of high profile trade disputes led policymakers in Congress to press the Obama administration to label China a "currency manipulator" and take punitive actions against Beijing. U.S. arms sales to Taiwan, U.S. President Barack Obama's meeting with the Dalai Lama, and Google Inc.'s (Nasdaq: GOOG) hasty retreat from the mainland further escalated tensions.

A one-hour phone call between Obama and Chinese President Hu Jintao and an impromptu meeting between Geithner and Chinese Vice Premier Wang Qishan in Beijing were finally able to diffuse the situation in April.

Hu in his opening remarks yesterday acknowledged U.S. calls for China to revalue its currency, but also said Beijing would move at its own pace.

"China will continue to steadily advance reform of the renminbi exchange rate formation mechanism following the principles of being independent, controllable, and gradual," he said.

The United States was content with that, knowing that if China fails to act on its currency in the months ahead, it will have to answer to a host of other foreign countries at the Group 20 (G20) summit in late June. Developed nations in Europe have traditionally supported U.S. calls for currency revaluation. In fact, the Eurozone imports more Chinese goods than even the United States. However, fellow emerging giants India and Brazil last month joined the parade of nations calling on China to take action.

Inflation also could force China into action on the yuan. China's consumer price index (CPI) rose 2.8% year-over-year in April, with food prices surging 5.9%.

"We expect the CPI to cross policymakers' 3% year-to-year threshold in May, which will be followed shortly by RMB appreciation and a 27-basis-point interest rate hike, though the exact timing of each measure is uncertain," Nouriel Roubini, a professor at the Stern Business School at New York University and chairman of Roubini Global Economics, wrote in a recent column for Forbes.

"China will likely try to avoid all appearances of caving to international pressure, which at this point seems to suggest July makes sense for RMB appreciation," Roubini added. "If that is the case, June will likely see a 27-basis-point rate hike, a move China's economy desperately needs."

A New Direction

With political support in tow, as well as domestic pressure on China to revalue its currency, the United States is free to step back from the currency issue and focus its efforts elsewhere.

For instance, Secretary of State Hillary Clinton is taking the opportunity to try to win support for tougher sanctions against North Korea and Iran.

An international investigation determined last week that a torpedo fired from a North Korean submarine sank the South Korean warship, the Cheonan, last March, killing 46 sailors.

In response, Seoul said it would sever most trade ties with the North and bar its ships from its waters. President Lee Myung-bak also said that his country would seek to get the issue raised at the United Nations Security Council, where Pyongyang could face new sanctions.

China is North Korea's biggest trading partner and only major ally. North Korean President Kim Jong Il just two weeks ago visited Beijing in an effort to further cement ties.

In her opening remarks at the summit, Clinton said the United States and China "must work together again" to press North Korea "to stop its provocative behavior, halt its policy of threats and belligerence toward its neighbors, and take irreversible steps to fulfill its denuclearization commitments."

China's Hu was more vague on the issue, saying the two nations share a responsibility for "managing regional hotspots" while "safeguarding world peace and security."

Clinton touched on the growing threat posed by Iran, another country China has been reluctant to oppose.

"The prospect of a nuclear-armed Iran concerns us all," she said. "And to address that threat, together we have pursued a dual-track approach of engagement and pressure, aimed at encouraging Iran's leaders to change course."

Beijing agreed to a watered-down United Nations resolution to address Iran's nuclear program, but has not signed off on sought after punitive measures against specific individuals and companies. The United States aims to clamp down on Iran's energy sector, an area in which China has made susbstantial investments.

As is the case with North Korea, China is Iran's largest trading partner. It gets some 15% of its imported oil from the embattled nation. Two-way trade between the two countries jumped by 47.4% year-over-year in the first quarter.

Among other things at the summit, China is asking the United States to relax trade restrictions on more advanced technology that could have military applications. But if Beijing is serious about gaining access to such technology it first will have to demonstrate that it is making global security a top priority and take a firmer stance on Iran and North Korea.

Additionally, both Clinton and Geithner called on China to ease restrictions on foreign companies operating within its borders. Geithner made particular mention of China's so-called "indigenous innovation" program, which demands that government procurement favor Chinese products.

China never signed the World Trade Organization (WTO) government procurement agreement that prohibits such favoritism – although it promised when joining the organization in 2001 that it would do so "soon."

Beijing has suggested that it would sign the agreement this year, but it has also asked for a 15-year phase in period.

Meanwhile, officials at every level of government across China have issued lists of products that can be purchased by their respective agencies, and virtually all of those items are made domestically. Shanghai, for example, released a list of more than 500 approved products, and just two of those items come from companies with foreign ties.

"I do think there has been a softening of China's position on indigenous innovation," said Geithner. "I don't think they've come far enough, and it's not something we're going to solve in this meeting. But they are sensitive to it."

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