By Peter S. Goodman and Paul Blustein
Washington Post Staff Writers
Wednesday, September 13, 2006; D01

http://www.washingtonpost.com/wp-dyn/content/article/2006/09/12/AR2006091201621.html

SHANGHAI -- Hunched over clattering machinery, the 170 workers at a factory here churn out gleaming pistons for auto engines by the crateful, driven by surging demand from abroad. To hear managers at Shanghai Datong Automotive Industrial Co. tell it, their success overseas is due to efficiency and rock-bottom costs. "Our technology is good, our wages are low and materials are abundant," said Jin Zhangfu, the plant's manufacturing supervisor.

But in the American heartland towns where auto parts makers are struggling to survive, an entirely different explanation -- China's cheap currency -- is proffered for the competitiveness of companies such as Shanghai Datong. Such complaints are expected to get high-level attention in coming days as the Bush administration's new Treasury secretary visits Asia.

Wes Smith, president of E&E Manufacturing Co. of Plymouth, Mich., a maker of fasteners and other auto components, blamed much of "the world of hurt" his company is suffering on Beijing's policy of keeping the value of the yuan tightly controlled at a level that, he said, gives Chinese manufacturers an unfair advantage.

"It's not that we're competing against the so-called dollar-a-day wage," Smith said. "It's that they subsidize their production with currency manipulation."

Criticism over China's currency policy has alternately flared and subsided for several years, but the problem is reaching a new and potentially explosive stage as the Chinese export juggernaut moves up the ladder from clothes, toys and televisions to goods such as auto parts.

The issue is to be debated this weekend at annual meetings of the International Monetary Fund and the World Bank in Singapore, and again during Treasury Secretary Henry M. Paulson Jr.'s visit to China next week. Although some economists view the matter as overblown, others say the yuan's exchange rate is so far out of line as to constitute a dangerous distortion in global trade.

At a hearing last month of a body created by Congress to study U.S.-Chinese issues, Brad Setser, director of global research at Roubini Global Economics LLC, said that China's exports, which were about $325 billion in 2002, are on pace to reach $950 billion this year, "an extraordinary increase" in a brief period. During that time, he added, the Chinese current account surplus, the broadest measure of the gap between exports and imports, has risen six-fold, to an estimated $220 billion in 2006, an amount equal to about 8 percent of China's total economic output.

That is simple but powerful substantiation that the yuan is grossly undervalued, in the view of Setser and other economists.

In 2002, the U.S. dollar began declining sharply against other major currencies including the euro, British pound, Japanese yen and Canadian and Australian dollars, but not the yuan, which the Chinese government kept rigidly pegged at 8.28 per dollar. Under pressure from the United States, China announced in July 2005 that it would raise the value of the yuan by about 2 percent and allow it to move more according to supply and demand. But Beijing's restrictions over money flowing in and out of the country have helped keep further appreciation to a minimum -- about another 2 percent, far less than the 20 to 40 percent that some analysts estimate is warranted.

Auto parts illustrate the phenomenon clearly.

China's rapidly growing auto industry used to depend heavily on imported components, but last year for the first time the country exported more auto parts than it bought from abroad. Sales to the U.S. market have leapt 39 percent, to $5.4 billion in 2005. Worldwide, China has set a goal of exporting $70 billion worth of parts by 2010--a seven-fold increase from last year's level. That is exacerbating the woes of a U.S. industry that is already struggling, as witnessed by Delphi Corp.'s Chapter 11 bankruptcy filing. And while labor costs explain much about why Chinese firms have penetrated such sectors as furniture, auto parts makers blame the currency as a decisive factor.

For example, Dura Automotive Systems Inc. of Rochester Hills, Mich., has manufacturing plants in 14 countries, including China. It sells parking-brake cables made in the United States for $4.50, on which it earns a profit of 35 cents. The sales price in the United States of comparable Chinese cables is $3.70, effectively less than the U.S. cost of production, said Larry Denton, Dura's chairman and chief executive.

"If I were to balance the currency at the appropriate level," Denton said, that is, by raising the yuan as much as the Australian dollar, British pound or euro have risen against the U.S. dollar in the past several years, "the Chinese sell price and the U.S. sell price would be nearly identical, at $4.50. We would compete in a level marketplace."

In a world where nearly all major countries have moved in recent decades to currencies that float from fixed exchange rates, China has kept a different system. Limiting capital inflows and outflows enabled China to keep the yuan steady and avoid the financial crises that struck its Asian neighbors in the late 1990s, a feat for which it earned international praise. The fixed-rate policy also helped tame inflation during the 1990s.

Now, however, a major factor behind Chinese policy is the fear that a rapid appreciation of the yuan would make exports less competitive, threatening jobs.

"Traditionally, China relies on exports for growth, and the government is very nervous about harming this," said 何帆, an economist at the Chinese Academy of Social Sciences in Beijing. "There would be huge unemployment."

Those worries may be understandable, given that a big rise in joblessness could threaten China's stability, but they show that Beijing's currency regime amounts to a beggar-thy-neighbor policy, some economists assert.

By allowing China to underprice its goods, the situation "enables them to export some of their unemployment to the rest of the world and take huge advantage of the currency misalignment," said C. Fred Bergsten, director of the Institute for International Economics in Washington.

The result, aside from the impact on companies and jobs in the United States, is a widening of the vast trade imbalances that could eventually lead to turmoil in the global economy, according to Bergsten and other economists.

The U.S. deficit with China accounted for more than a quarter of the $716 billion U.S. trade gap last year. That is why China's currency policy will be on the agenda at the IMF-World Bank meeting in Singapore. Top policymakers will discuss ways to shrink such imbalances for fear that foreign investors may become spooked by the burgeoning U.S. deficit and dump their holdings of U.S. stocks and bonds. The issue will also be center stage when Paulson meets with Chinese leaders in his first trip to Beijing as Treasury chief.

"We're going to ramp up and intensify our interaction with them," said Timothy D. Adams, the Treasury undersecretary for international affairs, citing Paulson's extensive experience in China when he headed the investment banking firm Goldman Sachs.

China needs to do a lot more than just allow the yuan to appreciate, Adams emphasized. Paulson's trip will also stress the need for Beijing to shift away from exports toward greater consumer spending. But Congress is pressing for action on the currency, with lawmakers threatening punitive tariffs on Chinese goods.

Some economists consider such demands misplaced. Ronald I. McKinnon, a professor of international economics at Stanford University, said that most Chinese products sold abroad are consumer goods assembled in China using components from Japan, South Korea, Taiwan and Thailand, among other places.

"China is merely the face of a worldwide export surge into American consumer markets," McKinnon argued in a paper published in July with a colleague, noting that at Christmas, when "American families open their presents, they see mainly made-in-China labels!"

According to McKinnon, a substantial rise in the yuan would lead to a fall in China's exports but would damage the Chinese economy so severely that the nation's demand for foreign goods would plunge as well, the result being no net shrinkage in the trade imbalance. That, McKinnon points out, is what happened with Japan in the last decade when it bowed to U.S. insistence on a rise in the value of the Japanese yen.

In recent months, a new issue has dominated the debate -- the risk that China's economy has overheated. Policymakers in Beijing are concerned that a boom in such fast-growing sectors as autos and real estate is leading to construction of more factories and office parks than China can use. The upshot could be a bust that would wreck the banking system.

Some economists assert that a higher yuan is precisely the right medicine. According to this theory, that would slow exports, limiting the buildup of China's foreign reserves and slowing the flow of funds into banks whose lending is fueling investment.

The Beijing government remains divided over how quickly to move, with the central bank urging a faster appreciation to prevent overheating and other ministries lobbying for little change.

Chinese exporters are vocal in opposing a rise in the currency. At the Shanghai Datong plant, Jin, the manufacturing supervisor, was asked recently what would happen if the yuan were to rise by 10 percent or so. He looked pained. "We couldn't afford that," he said.

Analysts say China's powerful State Council is striving to maintain a middle position, the most likely outcome being a rise in the yuan of perhaps 3 to 5 percent a year over the next two years.

"The consequences are so great that ultimately nobody can make a decision," said 茅 Yushi, chairman of the Unirule Institute of Economics in Beijing. "Everyone knows the [yuan] must appreciate now, but no one has the courage to make it happen."

Blustein reported from Washington.