The moves come as China has expressed ambitions about seeking a bigger role for its currency in global markets, especially with investor doubts mounting about the future of the fragile euro, and worries about the steadily weakening dollar. The package of measures—reached by Chinese Premier Wen Jiabao and Japanese Prime Minister Yoshihiko Noda, who arrived earlier in the day in Beijing—will help further that cause.

But the agreements are unlikely to have any immediate significant effect, and, for now, may be mainly symbolic. The governments didn’t announce any timetable for implementing the plans. And as long as China maintains strict controls on the convertibility of its currency, and investments in its economy, there are limits on how much further the yuan can expand internationally.

Still, the accords were striking, given recent tensions between China and Japan, including a prolonged diplomatic standoff just over a year ago in a territorial dispute, and hawkish comments by Mr. Noda and aides earlier this year about their concerns of a Chinese military threat. While China has reached agreements with other countries to encourage investment in its bond market and to encourage convertibility from the yuan into other currencies, this appears to be the most comprehensive such bilateral package. The moves suggest the two leaders may now see the need to downplay political differences and focus on reinforcing their economies, particularly at a time when Europe’s debt turmoil and flagging global growth threaten Asian growth.

The Wall Street Journal adds that while the deals may not have an impact anytime soon, they signal China’s willingness to make its currency more flexible:

Even so, the move is likely to be quietly welcomed by the U.S. government, which has encouraged China to seek a bigger role for the yuan. That’s because U.S. government officials realize—as do Chinese reformers—that for the yuan to play a much bigger role, China needs to broadly revamp its financial-sector policies. Morris Goldstein, an economist at the Peterson Institute of International Economics in Washington D.C. said those policies would include sharply reducing its exchange-rate intervention, liberalizing interest rates, reducing restrictions on capital flows and putting its banking system “on a more market-oriented basis,” so the yuan can trade freely.

Such policies are likely to put upward pressure on the yuan versus the dollar, which has long been U.S. policy. According to Chinese state television, Japanese officials notified Washington of the agreement ahead of the announcement and reiterated Japan’s confidence in the long-term prospects for the dollar. A U.S. Treasury spokesman didn’t comment.

China’s Ministry of Foreign Affairs denied the possibility of any near-term yuan appreciation in October, though it hit a record high against the U.S. dollar on Monday.

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“In the short term, pushing for rapid yuan appreciation is not possible. If Chinese economic growth slows, it will reduce global aggregate demand,” Ms. Jiang said.

In public comments about the issue, Chinese officials have stressed that yuan reform will be gradual, but haven’t explicitly said that rapid appreciation is off the table.

Standard Chartered economist Stephen Green projected Tuesday that the yuan’s appreciation against the dollar will slow to 3% to 4% in 2012 from 5.5% in 2011, due to China’s slowing economic growth.

On Wednesday, Bank of America-Merrill Lynch economist Lu Ting said that due to recent dollar strength, the yuan has actually appreciated by 4.1% against a broader basket of currencies since the end of July.

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While the Beijing papers worry about macro-economic and political consequences of the yuan’s possible revaluation, media in other, more economically dynamic regions of the country are concerned with the more immediate impact it would have on pocketbooks. On Oct. 17, Chen Xu, a columnist with Shanghai’s independent Oriental Morning Post, wrote that even though domestic politics are behind the U.S. push for currency revaluation:

It is impossible for the Beijing government to succumb to the external political pressure to appreciate the RMB and thereby harm their own export industry in the current global economic turbulence.

The editorial is mostly polite, until the end, when he sharply noted: “Beijing isn’t interested in the attitudes of Americans regarding this issue.”

That last point is almost certainly a blustery overstatement, and the proof is in the English: More than any other important Sino-U.S. issue in recent memory, China’s English-language newspapers have commissioned and translated currency-related editorials that speak directly to American audiences. Take, for example, a prickly editorial by Tao Wenzhao, a senior researcher with the Center for U.S.-China Relations at Beijing’s elite Tsinghua University. Hewrote:

Economic globalization has expedited international competition, as well as industrial structural adjustments in the U.S. Labor-intensive industries have become “sunset industries,” and the U.S. is outsourcing its manufacturing to other countries, including China.

Thomas Friedman wrote an Op-Ed in the New York Times titled “Imagined in America” where he urged that America must rethink the way it develops its economy.

We are never going to get those labor-intensive assembly jobs back from China — the wage differentials are far too great, no matter how much China revalues its currency. We need to focus on multiplying more people at the high-value ideation and orchestration end of the supply chain, and in the manufacturing processes where one person can be highly productive, and well paid, by operating multiple machines. We need to focus on “Imagined in America” and “Orchestrated From America” and “Made in America by a smart worker using a phalanx of smarter robots.” In total value terms, America still manufactures almost as much as China. We just do it with far fewer people, which is why we need more start-ups.

But we also need to stop thinking that a middle class can be sustained only by factory jobs. Thirty years ago, Hong Kong was a manufacturing center. Now its economy is 97 percent services. It has adjusted so well that this year the Hong Kong government is giving a bonus of $775 to each of its residents. One reason is that Hong Kong has transformed itself into a huge tourist center that last year received 36 million visitors — 23 million from China. Their hotel stays, dining and jewelry purchases are driving prosperity here. The U.S. Commerce Department says 801,000 Mainland Chinese visited the U.S. last year, adding $5 billion to the U.S. economy. More Chinese want to come, but, for security reasons, visas are hard to obtain. If we let in as many Chinese tourists as Hong Kong, it would inject more than $115 billion into what is a highly unionized U.S. hotel, restaurant, gaming and tourism industry.

Another idea officials here offer is that the United States invites Chinese firms to invest in toll bridges, toll roads, and rail systems across the United States, in partnership with American companies. They could build them, and operate them for a set number of years, until their investment pays out, and then transfer them to full U.S. ownership. It may be the only way we can rebuild our infrastructure.

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China, America’s largest creditor, increased its holdings of U.S. debt to a record $1.175 trillion in October, according to revised data issued by the Treasury.The Asian nation’s investment totaled $1.16 trillion at year-end, the Treasury Department reported yesterday, raising the figure from the previous $891.6 billion. Japan maintained its place as America’s second-largest lender, with $882.3 billion of Treasuries at year-end, compared with $883.6 billion before the revision.

China buys Treasuries with the dollars it takes in by selling yuan to keep its currency from strengthening, and with the funds it earns from exports.

Chinese President Hu Jintao told business executives in Washington in January that closer ties between his country and the U.S. were critical amid a “tortuous” global economic recovery.

This news once again reveals the extent of economic interdependency between the US and China.  China’s purchase of US Treasury bonds, along with its growing domestic inflation, has led to speculation that the yuan will definitely appreciate in the near future. Yesterday, US Treasury Secretary Timothy Geithner addressed this topic before the Senate Foreign Relations Committee. From the Wall Street Journal:

“The risk for them if they slow the pace of appreciation is that inflation will accelerate further,” Geithner told the Senate Foreign Relations Committee. “That’s why it’s inevitable that they continue to move, and of course, we want that move as quickly as possible.”

If they slow the pace of appreciation against the dollar, inflation is still running substantially above the U.S., by some measures three times the rate of growth in the U.S., the secretary said.

Including inflation, the yuan is appreciating against the dollar at an annual rate north of 10%, Geithner said. “If that were sustained, again, that’s a huge shift over time,” he said.

If it occurs, the yuan’s appreciation will undoubtedly affect the global economy.

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he Obama administration declined to name China a currency manipulator on Friday, even though it said the yuan was “substantially undervalued,” sparking fresh calls for legislative retaliation to try to reduce a swelling U.S. trade deficit.

Treasury said China’s yuan CNY=CFXS should rise more quickly but said it lacked evidence to label Beijing a manipulator, a designation that could trigger trade action.

[...] The United States had a trade deficit of $252 billion with China during the first 11 months of 2010. Some of the largest U.S. retail chains source the vast majority of their products from Chinese factories.

The United States also relies on China to buy the bulk of the weekly flood of debt securities that Treasury sells.

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Most economists have given up on China snapping the yuan’s peg to the dollar, which has persisted since the middle of 2008, as the emerging economic superpower has repeatedly rejected the idea.

However, the picture has changed somewhat this week, as the Chinese authorities have made it clear that they are determined to tackle early signs of overheating in the economy. Now, some heavyweight economists are starting to take the idea that currency strength could be a useful tool in that fight more seriously.

Speculation started to gather Tuesday, when the People’s Bank of China slapped tougher reserve requirements on its banks to pinch rampant lending, prompting market watchers to mull the chances of a straightforward interest rate rise.

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China is playing a growing role in discussions over solutions to current economic problems. Much of the talk has focused on money — whether Premier Wen Jiabao’s concerns about the value of China’s U.S. treasury investments, or the People’s Bank of China’s paper floating the idea of a de-dollarized international monetary system. Up to now, one limit to China’s ability to contribute to global monetary reform has been its own currency policy, particularly the fact that the yuan is not convertible. However, now there are tentative signs that’s starting to change.

Beijing has signed currency swap agreements with six central banks: Hong Kong, Indonesia, Korea, Malaysia, Belarus and most recently Argentina. These swaps permit those central banks to sell yuan to local importers in those countries who want to buy Chinese goods. This is particularly useful for importers struggling to obtain trade finance as a result of the financial crisis. As such, it’s consistent with China’s desire to participate in the Group of 20′s efforts to support trade financing.

China has long wanted its currency to play a more important role in the global financial system. These swap arrangements come in the context of that broader policy aim. The broader policy goal also has a more practical function in reducing currency exposure and transaction costs for Chinese exporters. The rise in the yuan’s value relative to the dollar in early 2008 was a reason why some Chinese exporters went bankrupt. The ability to settle trade in yuan would reduce this risk in the future.

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In its half-yearly World Economic Outlook report, the IMF said a more flexible yuan, or renminbi, would help China shift growth momentum towards domestic sources and make its monetary policy more effective.

“In the IMF staff’s view, the renminbi remains substantially undervalued relative to medium-term fundamentals,” the report said.

The IMF further predicted 9.7 percent economic growth for China in 2008 and 9.3 percent in 2009, down significantly from 11.9 percent in 2007, saying this was “partly because of slowing exports”.

Even so, it argued China’s heavily export-dependent economy would be better off if it allowed its currency to rise further.

At the same time, the IMF has warned that Asian economies in general will face slowing growth in response to the ongoing financial crisis in Western countries. From Forbes:

‘The main concern is that a buildup of stress in the global financial system and a sharper-than-anticipated global slowdown could further weigh on activity,’ it said.

Regional locomotives China and India will also experience slower growth on weaker exports, but should continue to be supported by solid private consumption, it said.

For more on this topic, see “On The Alert: Will China’s Financial Market’s Follow The US?” via CDT.

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Paulson, meanwhile, will be leading a delegation of Cabinet members to meet with their Chinese counterparts in Annapolis, Maryland, next week at what could be the last round of high-level economic talks under the so-called strategic economic dialogue started in 2006.

U.S. officials say that while a number of specific trade issues have been resolved over the past two years, they are increasingly concerned that China is backtracking by using regulations, standards and other means to favor Chinese industry and shut out foreign competition.

Paulson said Tuesday that he would press for a more open Chinese economy and convey “the concerns of American companies that China’s investment regulations are opaque and seem in many ways to be designed to favor China’s ‘national champions.”‘

Xinhua has a slightly different take on the story with their report headlined “Paulson: economic relations with China growing in positive direction.” See also CDT’s previous post: “Paulson Pledges Robust Engagement With China.”

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By closely linking the yuan with a sharply declining U.S. dollar, China is importing a highly accommodative U.S. monetary policy, which sits oddly with Chinese monetary policy considerations. On top of China’s already large, basic balance of payment surplus, speculative inflows likely have risen in recent months as yuan appreciation expectations have become entrenched. A combination of a one-off revaluation of the Chinese currency and tightened capital controls by government regulators may help break the expectation in the near term, although these steps would be highly controversial.

The speed of China’s foreign exchange reserves accumulation has been nothing short of astonishing. In a previous report (see “Country Alert China, Difficult 2008 Part I: The Speed of FX Accumulation,” March 17, 2008), we identified the influx of foreign exchange as one of the biggest challenges facing Chinese policymakers this year. Our estimate puts the actual increase of net foreign assets in 2007 at between US＄ 570 billion and US＄ 685 billion, and we are not surprised that FX reserves increased by more than US＄ 120 billion in the first two months of this year.

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