Welcome Pressure on the Yuan Is Back

by: Ryan Avent

Over the past few months, it has been interesting to observe which pre-recession trends or dynamics have reasserted themselves. We have a new entry into the category, it seems—the return of hot money inflows to China. Pre-crisis, foreign exchange was flooding into China above and beyond the levels attributable to trade flows and foreign direct investment, based on bets about the relative strength of the Chinese economy.

These flows came to a screeching halt and reversed during the worst months of the recession; during the first quarter of 2009 Chinese foreign exchange reserves grew by just $7.7 billion, and hot money actually left the country. With China's economic recovery looking more promising than turnarounds elsewhere, the flow has strongly reversed itself. Second quarter foreign exchange reserve growth hit nearly $180 billion, $70 billion of which was hot money. That growth pushed total Chinese reserve holdings to over $2 trillion.

The shift has important implications. China is quite obviously buying a lot of dollars in order to maintain its currency valuation. This is an important source of support for the greenback, and it also suggests that China's appetite for American debt will remain strong. Chinese Treasury purchases in 2009 are likely to be higher than in 2008, and the central bank may begin moving into other, riskier American securities as economic conditions continue to stabilize.

This is bittersweet from an American perspective. The existence of a ready buyer for American debt gives the government a freer hand to battle the recession. On the other hand, it keeps in place conditions that generated economic instability in the first place—a persistent American trade deficit and cheap debt.

But continued inflows will place pressure on the Chinese government to make further adjustments to the yuan's valuation, lest increases in security and property prices—and eventually, prices generally—get out of hand. Appreciation of the yuan would be welcomed by a great many people. It would improve the competitive position of exporters everywhere else and would increase the buying power of Chinese consumers; in short, it would be a nice step toward addressing major structural imbalances in the global economy. China doesn't appear to be anxious to fiddle with its peg while recovery remains uncertain, but that position can't be maintained for very long if strong Chinese growth does indeed return.

This article originally appeared on The Economist.com