Quotes of the Day

Some things in China are more expensive than they should be. Starbucks, for example, is marketed mostly to Westerners, and commands the same insane $4 price for a cup of coffee that it gets in the U.S. But many common items—clothing and jewelry, for example—are outrageously cheap: silk neck ties can be had for $1; a genuine pearl necklace may set you back all of $20.

The reason the dollar goes so far in China is that breakneck growth has turned it into a wealthier nation that can afford to keep its currency, the yuan, unnaturally cheap. That keeps Chinese goods inexpensive around the world, and keeps the growth engine humming. China exports so much stuff to the States, for example, that their trade surplus is nearing $200 billion.

Ordinarily, such an immense trade imbalance should strengthen the yuan and cheapen the dollar, with the resulting price adjustment leading folks in the U.S. to buy fewer Chinese goods. But China likes things the way they are: To prevent the yuan from strengthening, the government is buying and stockpiling dollars, creating artificial demand for the buck and holding the currencies in something close to lock-step. China now has more than $800 billion in dollar reserves and likely will move past Japan this year to be the largest foreign holder of dollar-denominated securities, including Treasury bonds.

China's policy is upsetting governments around the world, because keeping the yuan down gives Chinese producers an unfair cost advantage. But China is in no hurry to level the playing field. Foreign pressure to let the yuan rise reached the boiling point last summer, but Beijing's response barely noticeable: a modest 2.1% bump in the yuan with virtually no follow-through to let market forces set currency values.

Now, some pundits argue, the jig is almost up. After China surpasses Japan as the top foreign holder of dollars, international pressure will be impossible to ignore. And pressures will mount at home, too, as all those dollars sit in a vault earning embarrassingly little return.

Still, don't count on capitulation. The Chinese are terrified of turning their good fortune over to unchecked market forces. Only the threat of serious economic fallout will stir them to act decisively on their currency. Arguably, the one price they should be paying for their currency manipulation is runaway inflation. The artificially depressed yuan may make Chinese goods cheap to foreigners, but it also makes foreign goods expensive to folks paid in yuan. And the government is now printing money at a rapid clip to keep buying dollars. The growing pool of yuan chasing the same goods should send prices spiraling higher. Yet, says economist and China watcher Donald Straszheim, "inflation is one thing they do not have to worry about." The Chinese are such prodigious producers that there is little threat of shortages of finished goods. They just keep making more.

China's dollar policy is a mixed blessing for the U.S. Beijing's dollar purchases help keep our interest rates down. But it also puts our economic fate, to a degree, in foreign hands. How will this all work out? Fearful though they may be of pure economic forces, they are increasingly eager to secure their place among the global economic powers. Straszheim believes China will bring its currency value much closer to where market forces would put it by the time of the 2008 Olympics in Beijing, which the Chinese see as something of a coming-out party. By then, maybe they'll accept that a relatively free-floating currency is the price of admission for an economic superpower—one they can easily afford.

• Daniel Kadlec
• China is set to pass Japan as the largest foreign holder of U.S. currency