The Chinese Connection To Competitive Devaluations

For at least several months now, Chinese officials have been lobbing sharp tongued critiques toward the U.S. and its policy makers. The Chinese, who mastered proverbs long before the West, should know that people who live in glass houses shouldn't throw stones. Let's back up and recap a bit. During Treasury Secretary Geithner's confirmation hearings, he said that Obama "backed by the conclusions of a broad range of economists - believes that China is manipulating its currency."

For over a decade, China had "pegged" its currency to the U.S. dollar. A "peg" is a fixed exchange rate maintained by a country's government. In this case, the People's Bank of China (the Chinese central bank) exchanged dollars gained from trade into the local currency, renmibi ("RMB" for short; also called "yuan"). By exchanging at a fixed rate, the government can maintain the peg.

Due to the large trade deficit with China, western officials have been encouraging and pressuring China to let the RMB float. When a currency "floats", market forces of supply and demand set the "price" or exchange rate. This is how most major currencies operate and why the dollar buys more or less Canadian dollars or Pounds for example. When a country imports too much relative to exports, its currency can be expected to fall making the imports more expensive. Three or so years ago, under heavy political pressure, China relented and began letting the yuan float within a range. Gradually, the bank let the yuan appreciate from about 8.27 RMD per USD to 6.85 RMD/USD, some 17%. Look at the following chart- you can see just how orderly the appreciation has been.



Compare this to any currency chart and you will immediately see how smooth the change has been. Which means only one thing- the Chinese are smoothing the exchange rate by intervening in the market (here is the USD:EUR for comparison). In other words, it isn't a freely floating currency, it is one managed by the Chinese.

So, Geithner makes this "manipulation" comment and the Chinese respond with "In recent days persons in a Western country have said 'China is manipulating the yuan exchange rate'. These remarks are not only inconsistent with the facts, but they are misleading about the reasons for the financial crisis." (People's Bank of China Vice Governor Su Ning). Let this posturing set the stage.

Two weeks later, Bloomberg reports an audacious statement from the Chinese, made through high ranking executives not in an official capacity. Bear in mind, this is how ideas are "leaked" to the markets- often in an indirect fashion. Yu Yongding, a former advisor to the central bank, said on Feb 11 that the U.S. "should make the Chinese feel confident that the value of the assets at least will not be eroded in a significant way." In the same article, He Zhicheng, an economist a the Agricultural Bank of China (China's 3rd largest bank) said about Clinton's upcoming visit "In talks with Clinton, China will ask for a guarantee that the U.S. will support the dollar's exchange rate and make sure China's dollar-denominated assets are safe."  Those are some bold demands, my friends.

Apparently, Hillary did not mollify the Chinese on her visit. Just last week, Bloomberg reported that China's Premier Wen Jiabao said "We have lent a huge amount of money to the United States. I request the U.S. to maintain its good credit, to honor its promises and to guarantee the safety of China's assets."

A communist leader running a rigged economy has the gall to challenge the safety of U.S. Treasuries when his own country prints enough money to manipulate its exchange rate in favor of an unsustainable trade surplus that it benefits from enormously? (For the full effect, read the whole article on Bloomberg here.) In other words, Wen is declaring U.S. Treasuries a credit risk as the leader of a country with a massively unbalanced economy, poorly capitalized banks that operate on bribes/political will and undeveloped captial markets, which is dependent on exports and a manipulated currency.

Despite the facts, there has been little outcry here in the U.S., which I find puzzling. If I may speculate a little here, I think China is bluffing for their domestic audience. In poker, there is an old saw "strong is weak; weak is strong" which means the weak hand plays tough in an attempt to bluff. China is a country that must create tens of millions of jobs each year to pacify the masses of workers migrating to the cities from the interior. It is a country founded on civil unrest, struggle, and starvation, not too far in the past. Its leaders put economic growth as priority #1. But China is not immune to the world's economic troubles as evidenced by dramatically slowing exports which comprise some 40% of Chinese GDP. These economic headwinds are making Chinese leaders take bold steps in fear or even desperation. What better way to shore up support than to point the finger at a foreigner? (Also note recent Chinese nautical aggression towards U.S. ships. Provoking an incident would play well into the bad U.S. image they seek to create.)

Back to the currency and debt purchases. Obviously, China doesn't have to purchase our debt. They can simply accumulate dollars and sit on them. That won't do them much good, though, as it will drain the U.S. economy of some liquidity, further hurting export opportunities. As we have discussed in the past, China keeps its currency artificially weak to maintain an export advantage and the growth associated with it. They recycle the dollars into U.S. debt, so that we can continue to purchase Chinese exports while they earn a return on those dollar reserves. If they pull back on this arrangement now, they will hurt themselves as it will force us to purchase even fewer Chinese goods. That is a chance they aren't likely to take.

Yet it gets even more complicated. The Swiss (you didn't see a reference to the Swiss coming, did you?) have begun "quantitative easing" to stop the appreciation of the Franc. Quantitative easing is the term used when a nation's central bank buys assets to inject currency into the market. It is the central banking equivalent of printing money. And the Swiss, who are export dependent, are using QE to specifically make their currency and thus exports more competitive. So, with the Bank of England and the Swiss manipulating their currencies and hints that the Fed will do so in earnest soon, who can turn to China and say "hey, cut that out"? This crisis seems to be turning a corner of sorts into a world of competitive devaluations, but it's very hard to tell what effects these actions will have and the direction the world economy will take as a result.