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China’s currency peg is a gift to Europe

by Melvyn Krauss

PALO ALTO, Calif. — Europeans are wrong to be angry with China because its currency peg to the dollar has boosted the euro against most currencies on foreign exchange markets. They should view the currency peg as a valuable gift.

In New York and other U.S. cities, European shoppers are enjoying the euro’s enhanced purchasing power abroad.

The currency peg has also helped make the euro into a reserve currency rivaling the dollar. Investments from all over the world are flowing into Europe as a result.

It was predictable that China’s currency peg would have this effect. It forced China to accumulate huge amounts of dollars to stabilize its currency and gave the euro an extra boost as the dollar depreciated.

To protect itself from the declining greenback, China and other countries are converting a portion of their dollar reserves into euros. The International Monetary Fund estimates that the euro’s share of foreign exchange reserves rose to 26.4 percent in third quarter of 2007 from 25.5 percent in the second quarter of 2007, and 24.4 percent in the third quarter of 2006.

The euro’s becoming a major reserve currency bestows important economic advantages on the euro-zone economy. Europeans should thank the Chinese currency peg for the part it is playing in this.

Of course, with an augmented supply of euros, China can be expected to make substantial investments in Europe, which also is a good thing, especially since, in the United States at least, China has demonstrated a preference for investments in financial institutions rocked by the sub-prime crisis. Europe has plenty of those.

So far, China’s biggest European investment has been in the Belgian financial company, Fortis N.V., where Ping An Insurance recently acquired a 4.2 percent stake, making it the largest shareholder in the company. China Development Bank also made an investment in Barclays to bolster its bid for ABN AMRO which, though it failed, helped the Dutch bank get the full value for its assets.

This is only a start. Merrill Lynch predicts that, as currency reserves climb in countries like China, state-run investment funds will grow to from $1.9 to $7.9 trillion.

China’s currency peg has also come in handy for Europe in its fight to keep inflation in check, while its monetary policy remains constrained by the subprime crisis. Experts say that, in terms of guarding against inflation, the euro’s appreciation has been equivalent to about 35 basis points rise in the interest rate. The strong euro has helped insulate Europe from skyrocketing oil and commodity prices, which are priced in dollars on the world markets.

The big downside of the currency peg for Europe is supposed to be exports. That’s what sent French President Nicolas Sarkozy and other European officials scurrying off to China in November — and why many Europeans continue to think of the Chinese as not playing by the rules.

This is protectionist thinking par excellence. What makes exports so special? Why are they more important than cheap imports or the bargains that European shoppers get in New York? Should Europe give up all the advantages of the currency peg just because it makes European exports more expensive? Of course not!

Note that it was Sarkozy who went to China to protest the currency peg, not German Chancellor Angela Merkel. German exports are not being substantially damaged by the strong euro — indeed, German costs are so competitive that exporters are confident they can cope with the euro at $1.50 and even higher.

Reduce costs and France too will be able to cope with the strong euro.

In the final analysis, cutting costs is all the Europeans can do if they want to preserve the competitiveness of their exports. The Chinese are not going to change their exchange rate regime, which has strategic as well as economic motivations, just because the Europeans are unhappy with the currency peg.

China has given the Europeans a gift. They should be grateful, rather than foolishly insist that China take it back.

Melvyn Krauss is a senior fellow at the Hoover Institution, Stanford University. Copyright 2008 Project Syndicate (www.project-syndicate.org)