Why China should let the yuan rise

NEW YORK (CNNMoney.com) -- The Chinese have rarely given into foreign pressure to revalue their currency higher. But that doesn't mean they won't let the yuan rise later this year.

The Chinese have kept the yuan pegged to the dollar for almost three years. The currency is now about 20% to 40% below where it would be if it traded as freely as most other currencies, according to most estimates.

This keeps Chinese exports cheap, and has been blamed for the widening trade gap between China and the United States, as well as the loss of manufacturing jobs in the United States. President Obama and members of Congress have called for the Chinese to allow a rise in the yuan's value.

China did let the currency rise about 20% over three years starting in mid-2005. But it has moved very little since the summer of 2008. And few economists believe that the United States will be able to pressure a change in Chinese policy by itself.

"The Chinese do everything because of what it means to them internally. They don't respond to outside pressure," said Jay Bryson, international economist with Wells Fargo Securities.

But Bryson is among the growing group of economists who believe the Chinese will allow the yuan to start to rise later this year. He expects it could gain as much as 15% between now and the end of 2011.

"I don't think growth will be their issue a year from now. I think inflation will be the issue," he said. "One way to offset that is through a stronger exchange rate."

The typical view is that the Chinese government needs the yuan to be cheap to keep factories churning out exports and unemployment low. But a rise in the price of staples such as food can be an even greater problem, said Kurt Karl, an economist with Swiss Re.

"Inflation can be a real social problem," he said.

Other experts don't agree. They believe that prices are still relatively in check in China and that the global recession hit Chinese exports hard, even with the low value of the yuan.

"This is not 2005 when the world was really a better place," said currency trader Ashraf Laidi, chief market strategist at CMC Markets. He expects the Chinese to allow only a modest rise in the yuan's value, unlike the move in the middle of the last decade.

Calling China's bluff? Some argue it will take a coordinated effort by the United States and European governments, using the World Trade Organization, to get the Chinese to change its stance on currency.

"I think significant appreciation is not in the cards if the Chinese are left to their own devices," said Simon Johnson, an economist and professor at the Massachusetts Institute of Technology.

But Johnson isn't optimistic that the U.S. government will take the steps needed to build that kind of pressure. He said he doubts the Treasury Department will even characterize China as a currency manipulator in its next report to Congress on the topic on April 15, despite the massive intervention by the Chinese government to keep the yuan pegged to the dollar.

"Unless you label them a currency manipulator, you can't do anything else," he said.

There are risks in pushing China to let the yuan rise, given the massive Chinese purchases of U.S. debt and dollars. If China sold or even stopped those purchases, it could cause Treasurys to fall in price, raising interest rates and possibly choking off the nascent economic recovery in the U.S..

But Johnson argued at a recent congressional hearing that such fears are unfounded. He said low U.S. inflation and only modest growth should keep a lid on rates and that is in China's best interest not to cause a crash in the value of the Treasurys it holds.

"China's threat to react by selling Treasurys is at worst a bluff, and at best a way to help the U.S. with a depreciation of the dollar," he testified. "This bluff should be called."

Johnson said this week he believes a stronger yuan would help the U.S. economy, but he doesn't expect it will lead to a jump in hiring.

"This is not a jobs strategy. This will not make the recovery miraculously faster. You're not getting those jobs back with very few exceptions," he said.

Not everyone believes the Chinese yuan is grossly undervalued.

Hedge fund manager Jim Chanos argues that estimates of the yuan's value are based on inflated growth readings for the Chinese economy, and that he thinks China is a bubble that will pop relatively soon. But he admits that's a minority view.

"If there's one given out there in the financial markets right now, it's that the yuan is undervalued," he said. "Anytime everyone in the markets believes something is a given, you might want to test the assumptions."