NEW YORK (CNN/Money) - When it comes to what may be the world's biggest deflationary threat -- China's insistence on pegging its currency, the yuan, to the dollar -- the policy of U.S. and other world leaders has so far been strictly hands-off. This may not be the case for long.
China has kept the yuan (its official name is the renminbi) fixed at about 8.3 yuan to the dollar since the mid-1990s. For any other big exporter, keeping this peg would be a near-impossible task. Last year, China sold $125 billion in goods directly to the United States, according to the Commerce Department, a big shift up from 2000, when China's U.S. exports came to just $82 billion. Meanwhile, the United States exported just $22 billion in goods to China in 2002.
With China selling more and more to the United States and the rest of the world, and with it receiving a growing stream of investment from abroad, the natural expectation would be for the yuan to strengthen.
But China has prevented that from happening, first by not converting many of its overseas profits back into yuan (its central banks foreign currency reserves have nearly doubled since the end of 2000, touching $316 billion at last count), and also by closely regulating the foreign-exchange market in China and limiting foreign access to its currency.
If the yuan were allowed to float freely, said Foreign Exchange Analytics' David Gilmore, "the market would jump all over it. The yuan would have something like a 20 percent appreciation right off the bat. You could even end up with a 50 percent jump."
The yuan's apparent undervaluation is a tremendous help for the Chinese economy which, although it is growing quickly, is hampered with a badly damaged banking system, a steady migration from rural areas into cities that threatens to swell the ranks of the urban unemployed and, now, SARS. This keeps China's exports cheap, giving its manufacturers a tremendous advantage as they compete across the world. It also widens the appeal for foreign multinationals to open plants in China.
Time to change tactics
But China's cure may be the rest of the world's poison. With the dollar falling against most currencies, the yuan is falling with it, putting the pinch on many of the world's exporters. As they lose share to China, more of their production stands idle, adding to overcapacity problems and forcing them to keep prices down, or even cut them.
The potential for deflation is apparent enough that the world may soon be clamoring for China to raise the value of its currency. So far this has not happened. In a time of global instability -- think North Korea -- nobody wants to risk angering the sleeping dragon. Manufacturers are getting squeezed by the yuan, but many have also set up operations in China to take advantage of inexpensive labor, and they all dream about the profits they'll cull some day from 1.3 billion potential consumers.
Even so, enough will eventually be enough.
"It makes sense for the U.S., and also for the European countries, to ask for China to revalue the renminbi -- that will be the fastest way to sort out the deflation concerns," said Carlos Asilis, a portfolio manager with the hedge fund Vega Asset Management. "Unfortunately, for China that is going to be hard to respond to."
A number of immediate impediments keep China from moving on the yuan. First, and most obviously, the country is still dealing with the SARS epidemic, the ultimate economic consequences of which are a big unknown. Second, its leadership is new to the job -- Wen Jiabao formally took over as prime minister in March -- and will be unwilling to change the exchange regime until it gets its bearings.
Political pact preserves status quo
Then there's that problem at the banks. China officially reckons that about a quarter of the loans on their books are unlikely to be paid; outside observers tend to think the problem is twice as bad. But swallowing the bitter pill and letting many of its banks fail under the weight of their bad loans is not a political option for China.
"The thing to really remember with these guys is that there's a pact between the government and the people," said Brown Brothers Harriman fixed-income portfolio manager Richard Koss. "We keep a monopoly on political power and in exchange the economy grows fast and you have the chance of getting rich."
So how does China deal with its problem loans? By hoping that it can keep growing exports, and thus keep growing, enough to bail itself out of the problem.
But eventually, thinks Asilis, there will come a point where China will need to cede some ground on its exchange rate. The pressure from abroad will be too intense, and worries over the global economy -- from which it derives its growth, after all -- will be too tough to ignore.
"Ultimately, the renminbi will be revalued, no question," he said. "The question is, does deflation hit us before we get to that point?"