China's dim sum

US Treasury Secretary Hank Paulson heads to Beijing this week at a sensitive time.

The last month has seen US allegations of Chinese espionage, Steven Spielberg's high-profile resignation from the Beijing Summer Olympic Games, and questions over the safety of a drug compound shipped from China to the US for the manufacture of heparin.  

There is another bee in Washington's bonnet: the weakness of China's yuan.  

Doing Congress' bidding

Representatives of both parties in Congress have long argued Beijing is guilty of deliberately undervaluing its currency in order to boost the competitiveness of its exports, and have sought to introduce bills that would impose tariffs or other sanctions if China does not revalue by around 20%.  

Paulson will do Congress' bidding in encouraging currency appreciation, yet as an economist he may have private doubts it will do much to improve the state of the US economy. An undervalued yuan has many advantages for the US:

• US consumers benefit from cheap imported goods;
• US-based multinationals make large profits by exploiting cheap production and labour costs in China. 

Secondly, increasing the value of the yuan could actually increase the deficit.  In the global economy, China is the world's finishing-shop.  It imports intermediate goods from neighbouring countries before sending them on as finished products to the US and Europe. This means Beijing actually runs a considerable trade deficit with other East Asian countries.  Thus, if the yuan were to appreciate, China would be able to buy its inputs more cheaply, which could have the effect of actually reducing the price of its exports to the US.

Paulson also knows the Chinese have little incentive to allow their currency to appreciate too quickly. A sharp appreciation could cause the haemorrhage of Chinese jobs to other emerging markets such as Vietnam, and relative losses on dollar-denominated US government bonds held by Beijing.  

West: increasingly dependent?

Paulson may see his real challenge as easing China into the world economy. Despite recent reports about the dangers of Chinese inflation, the economic health of West is increasingly dependent on China. 

China's astonishing success may have caused fundamental imbalances in the world economy, but the means of addressing those imbalances may lie in reform within China itself, not externally imposed currency manipulation.  Boosting domestic consumption, relaxing capital controls and reforming taxation laws would do more to wean China off its export dependency than bowing to the wishes of Congress.