THE ALMIGHTY YUAN

Old habits are hard to kick, particularly profitable ones. The Asian practice of fixing currencies to the American dollar at rates that boost exports is back, seven years after it collapsed in the currency crises of 1997. A chain of de facto currency pegs have resurfaced, most famously in China and Japan, but also in such countries as South Korea, Taiwan, and India.

Alleged currency manipulation in Asia is likely to be the 800-pound dragon at the G7 and IMF meetings in Washington this week. Rising imbalances between the Far East and the United States, say economists, is subverting the U.S. Federal Reserve's ability to manage interest rates and could destabilize the global economy. But neither the fund nor Washington have been able to do much about it. In the last two quarters, foreign central banks purchased dollars and U.S. securities at an annual rate of $402 billion, up from $248 billion last year.

Asian governments accounted for 80 percent of the foreign inflows, accelerating a trend led by Chinese-government dollar-buying that keeps the yuan cheap relative to the U.S. currency. That in turn obliges the region's other export powerhouses to do the same. "This all started as a way for Asian economies to compete and do business with China," says Laurie Cameron, head of global foreign exchange at JP Morgan Private Bank in New York. "They want to export to the U.S. but also to China, to participate in the China explosion. It's as much a peg to the yuan as it is to the dollar."

The return of fixed exchange rates to the Far East comes with a few ironic twists. Before the 1997 crisis, many Asian currencies were officially pegged to the dollar, albeit with low reserves to back them up. In the mid-1990s, speculators sensed those currencies were overvalued given the region's high debt levels and began to sell them short. That prompted Asian central banks to drain their dollar reserves in defense of their currencies, which only delayed the collapse.

Amid the wreckage, China resisted the urge to depreciate the yuan to keep pace with its neighbor's collapsing currencies and was hailed as a stabilizing agent. Today Beijing is under fire as the vanguard of a new generation of Asian mercantilism. And other Asian governments are aggressively buying dollar assets--the opposite of their tactics in 1997, but with the same strategic end: aggressive export promotion.

After the crisis, many Asian governments lifted the controls and import barriers they had used to limit domestic spending, so capital could be funneled into export companies. With many of those restrictions lifted, often by IMF fiat, Asian governments are turning to currency manipulation to revive the export-led growth that led the boom of the 1970s and 1980s. "This is not in keeping with the spirit of financial liberalization because it makes these countries less efficient," says Peter Morici, an economics professor at the University of Maryland. "At some point the U.S. can no longer absorb all these goods. Look what happened to Japan."

The IMF called on Asian central banks to end currency devaluation last year. Flexible exchange rates, it said, would ease Asia's dependence on exports, empower Asian consumers, and lessen the odds for future economic crises. Since then, Asia has ramped up dollar-buying, and the cheap yuan is now being attacked in the U.S. presidential election for inflating America's near $600 billion trade deficit. Less understood, say economists, is how Asia's appetite for dollar assets neutralizes America's ability to manage interest rates. While the Fed is raising overnight rates to forestall inflation, long-term interest rates have remained stubbornly low on Asian demand for U.S. treasuries, which drives rates down. "The Fed may decide overnight rates," says Gary Hufbauer, a fellow at the Institute for International Economics in Washington. "But when it comes to the long-term money, China is the heavy hitter."

The central banks of Japan, China, South Korea, Taiwan, and other Asian countries account for $1.5 trillion in official foreign-exchange reserves out of a global total of $2.5 trillion, according to the IMF, a ratio that is far beyond that of Asia's share of global trade and global gross domestic product. Even India, which until recently was so starved for liquidity that it borrowed from Indian residents living abroad, has been supporting the dollar against the appreciating rupee.

It's not always clear where legitimate dollar-buying ends and exchange-rate manipulation or "spoofing" begins. Asian central banks routinely deny they devalue their currencies to gain a competitive advantage and both the IMF and the U.S. Treasury Department have effectively absolved them of spoofing charges. The White House has in general turned aside demands from lawmakers, unions, and the steel and textile industries to retaliate, particularly against China.

Washington holds a weak hand so long as it relies on foreign funds to finance deficit spending. China has met every entreaty on the value of the yuan--from White House envoys, IMF delegations, and U.S. manufacturers--with the same response: studied equivocation. "The Chinese have got the U.S. by the throat," says William Barron, managing director of Deutsche Asset Management in London. "When China stops buying dollars, the age of cheap capital is over." But China plans to move to a floating currency at its own pace, with an eye to stabilizing its own economy. So don't expect the gorilla at the IMF table to make any sudden moves.