IT'S THE MARKET: China's goods will remain cheap not because of its currency, but as a result of prices being tempered by the market forces of supply and demand. -- PHOTO: BLOOMBERG

Evidently, folks on Capitol Hill haven't been paying attention to the currency market. If they had, they would have realised that China's currency has risen just under 0.3 per cent against the US dollar since the Federal Reserve lowered its benchmark interest rate on Sept 18.

This might not immediately seem much, but by the day before the rate cut, the yuan had appreciated just over 9 per cent in two years since its July 2005 unpegging from the dollar. And remember, two percentage points of that came immediately with the de-coupling itself. Even including this, the recent rise in the yuan has been at a pace around twice as quick as in the past 26 months.

Will this bit of news stop US legislation going forward? Unlikely. Too many people have too much invested in the idea to let go. Nonetheless, those less ideologically inclined might take the opportunity to test the theory that the US trade deficit with China simply is a function of an unfair advantage from an undervalued yuan. What they will discover is that a rising yuan has no appreciable effect on the export price of Chinese goods.

The yuan's rise is a consequence of the dollar's overall, and deepening, weakness, as well as the belief that China will continue to tighten monetary policy in the face of rising consumer prices and sharply appreciating investment assets. In other words, it is rising as much as a result of prescriptions against inflation.

If China has been exporting deflation the past decade, inflation on the world's factory floor and a rising currency have now sparked the notion that it is set to export inflation. But in fact, Chinese inflation isn't likely to contribute to increases in export prices, while the rising currency hasn't made Chinese goods any less competitive.

Mr Chi Lo, research investment director of Ping An of China Asset Management (Hong Kong), explains it this way. While China has seen strong export growth, averaging 29 per cent year-on-year in the first half of this year, that strength hasn't brought with it pricing power. On the contrary, export prices in yuan terms have been falling at an annual rate of over 4 per cent.

One reason, Mr Lo says, is that much of China's inflation has been in food. Excluding this and energy, core inflation has been hovering at around 1 per cent since 2005. This means there has been little spillover into the wider economy, including the export price of goods.

Concurrently, Beijing has been trying to curb China's export growth and rebalance the economy towards a greater degree of domestic consumption. Much of this exercise targets low value-added, labour-intensive industries - 'grunge' manufacturing. But while this rationalisation has reduced excess capacity, it hasn't eliminated it.

Indeed, over-capacity continues to be a serious problem in the grunge sector. The result, as Mr Lo puts it, is that 'a fall in export growth will cut capacity usage, aggravate the over-capacity problem and trigger domestic price wars as manufacturers scramble to survive'.

Neither will export prices be pressured upward by a tight labour supply, as has been speculated. Mr Lo contends that China continues to have a labour glut, with reserves obviously remaining in the hinterland, and that reported shortages are essentially of urban, skilled employees.

That said, capital spending in the past several years - accounting for over 40 per cent of GDP - has not only added to capacity, but also improved productivity. And this alleviates the squeeze in skilled labour that might have caused a spike in unit costs.

Prices are determined by a range of issues, but conspicuously absent among these is exchange rate. China's goods have been cheap, and will remain cheap, not because of its currency, but as a result of prices being tempered by the market forces of supply and demand.

At the end, prices of China's goods remain so low compared to those from other economies so that the exchange rate - that supposed 'unfair advantage' - has little effect on final prices.

Thus, instead of a rise in the cost of Chinese-made goods that American politicians expect when they call for a sharp revaluation of the Chinese currency, China's price-competitiveness will be little changed.

'Trade is not about exchange rates,' says Dr Enzio von Pfeil, CEO of Commercial Economics in Hong Kong, who believes that mistakes made by American politicians actually threaten the viability of American companies.

'The bulk of Chinese goods going to America is imported by US companies, and a substantial portion of that is produced by American companies or American joint ventures.'

By wrongly seeing currencies to be the key driver of trade and then threatening punitive measures against China for its currency policy, protectionist politicians in fact threaten American businesses, American consumers and, by extension, the global economy that depends on American appetites.

The irony of the various prescriptions advocated in the US is that they aren't only viewed as anti-Chinese on this side of the Pacific, but could also be seen as anti-American by US consumers.

If anything could cause hesitation in the rush to erect barriers to trade flows, this might do the trick.

tionkwa@sph.com.sg