Dealing with "manipulation" of the yuan

I have been reading many reports on the pressure from the US and the EU on China to revalue its currency to reflect "market realities". How should the US and EU deal with Chinese currency "manipulation"? I think the US and EU should just sit tight and do nothing.

China has had a significant trade surplus over the last many years (over $800 billion in just the last four years). China's trade surplus peaked last year at around 9% of GDP. In 2009, it is expected to be around 5% of GDP. China's huge trade surplus and its rising economic power has increased pressure on elected officials in the US and EU to act on China's "currency manipulation". Chinese premier Wen Jiabao rejected the calls for currency revaluation as "unfair". "Their measures are restricting China's development" Wen Jiabao said.

There is no evidence that revaluing the yuan will have a positive effect on the unemployment statistics in the developed world. Former Federal Reserve Chairman Alan Greenspan mentioned in 2005 - "I am aware of no credible evidence that ... a marked increase in the exchange value of the Chinese [yuan] relative to the dollar would significantly increase manufacturing activity and jobs in the United States." I agree with Greenspan. There is not much of an overlap between the exports of China and the US and EU. If China revalues its currency, the US and EU imports will move from China to some other country (say India or Taiwan or Vietnam) or increase inflation in the developed world instead of creating jobs in the developed world.

Even if we assume that there is a correlation between Chinese currency appreciation and jobs in the developed world, the US and EU cannot do much. The WTO does not have too many rules against currency manipulation. There is no consensus that the China's pegging of yuan to the US dollar (which many people think is currency manipulation) would qualify as a "subsidy" under the WTO treaty. Hence it would be difficult to force China to revalue its currency under WTO rules.

Market forces will eventually force China to revalue its currency (when it revalues is anybody's guess). Today, People's Bank of China keeps its currency artificially low by absorbing dollars from the market and investing them in US Treasuries. This increases yuan in circulation, increasing inflation in the process. The central bank has to then remove these additional currency in circulation by issung bonds (at an interest rate much higher then the interest rate on US treasury securities). The cost of doing this is very high - the interest rate differential of around 5% would amount to over a $100 billion per annum on a $2 trillion reserve! This process of running huge trade surpluses and accumulating reserves will become increasingly unsustainable.

Bottomline - there is neither a need nor a way to force China to appreciate the yuan. Sit tight and leave yuan revaluation to market forces.