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China’s Yuan: Beware What You Wish For

Should the U.S. Congress really be pushing China to revalue the yuan?

May 6, 2005

Should the U.S. Congress really be pushing China to revalue the yuan?

For several years now, the Chinese leadership has been inundated with U.S. demands — from the Bush Administration and ever more prominent members of Congress on both sides of the political divide — to revalue the yuan.

For example, in late April 2005, the U.S. Senate voted with a 67-33 margin to threaten China with a 27.5% import duty — unless the PRC revalues its currency within the next six months.

The heightened pitch of U.S. complaints is partly due to the boom of textile imports from China following the expiration of the Multi-Fibre Agreement (MFA) with its quotas.

Even Europeans, who had been quite agnostic about the U.S. crusade against the yuan, have come on board as their current account surpluses with China are slowly turning into deficits as well.

But the Bush Administration, the U.S. Congress and anyone else interested in jumping on this rapidly accelerating bandwagon would be well advised to check the course ahead — since they are heading downhill without brakes.

The speed might still be broken by Chinese reluctance to be bullied into a decision they are not yet ready to make.

And even if the United States would implement 27.5% import duties on Chinese products six months from now, such an action would do little – if anything — to change U.S. trade patterns, rising current account deficits and large public sector dissavings.

Yet, assuming for a moment that the Chinese would indeed let the yuan float, the consequences for the U.S. and the global economy could be catastrophic.

Worst-case scenarios rarely come true. But the simple fact that such events, as outlined below, have moved from “highly unlikely” to “somewhat plausible” should give serious pause to U.S. policymakers.

In an effort to keep the yuan stable against the U.S. dollar, PRC authorities have bought huge amounts of U.S. dollars over the last few years.

This action has caused many of China’s neighbors to do the same in order to keep their respective currencies from appreciating, which would further weaken their competitive position vis-à-vis China.

In 2004 alone, the PRC, Taiwan, Hong Kong, South Korea and Japan added over $300 billion to their reserves, largely in U.S. government securities.

This government-to-government lending — in contrast to private sector-to-private sector lending and equity investments during the 1990s — financed nearly half of the U.S. current account deficit in 2004.

It is this imbalance that worries many economists. Foreign investors are no longer flocking to the United States in search of higher yield in U.S equity markets.

Instead, Asian governments are desperate to avoid a strengthening of their currencies and hence are financing America’s fiscal profligacy. Hundreds of billions worth of U.S. government bonds are stored in the vaults of Asia’s central banks for this purpose.

It is just like the age-old war on drugs. Who is to blame: The addict — or the supplier? Not surprisingly, it has always been easier to blame the supplier than to look at one’s own society of users — and the causes for such self-destructive behavior.

There is only one way to change this relationship radically and instantly. With a penchant for Greek tragedies, U.S. policymakers — and increasingly European ones — are in fact recommending such a change.

If Chinese authorities were to float the yuan and the currency would indeed appreciate significantly, China’s thirst for U.S. government securities would be quenched almost immediately.

Instead of piling up low-yielding U.S. treasury bonds, the Chinese monetary authorities could allocate their capital more efficiently. They might even be tempted to sell some of their existing stocks of dollar-denominated securities.

This new trend would be mimicked by China’s neighbors faster than you can spell “dumping.” For the first time in years, other Asian central banks too would no longer feel compelled to contain the appreciation of their respective and largely floating currencies.

They would no longer need to artificially prop up an ailing U.S. dollar in order to stay competitive with the PRC.

At that point, the U.S. dollar would likely plummet like a stone — and to levels far below the psychologically important marker of $1.50 to the euro. Even worse, this dollar sell-off could well turn into a global financial panic.

As central banks around the globe would see the value of their U.S. dollar reserves fall, they might exit the world’s reserve currency at an accelerating pace — only to put further downward pressure on the dollar.

Of course, oil prices would sky-rocket beyond $70 a barrel — as oil exporters too would seek to protect the value of their exports. Oil prices are denominated in dollars — and as the value of the dollar falls, so does the purchasing power of oil-producing countries.

Already, some oil producers have suggested that oil prices should be denominated in euros — or a basket of different currencies — because of the recent sustained weakness of the dollar.

Suddenly, the Bush Administration would see value in a coordinated G-7 multilateral plan to save the dollar, only to find that globalization of capital markets has rendered agreements such as the 1985 Plaza Accord virtually ineffectual.

Therefore, in order to attract enough capital inflows to allow for a timely refinancing of U.S. government debt — and to avoid a debt default — the U.S. Federal Reserve would have no choice but to raise U.S. interest rates.

And rather than the quarter-point increases of late, a free-falling dollar could necessitate interest hikes into double-digit levels — even as U.S. growth might slow. The situation could become reminiscent of former Fed Chairman Paul Volcker’s desperate and ultimately effective, but very costly monetary policy in the late 1970s.

This confluence of economic shocks would likely trigger a deep recession in the United States. Double-digit U.S. interest rates would also dry up capital flows to emerging markets.

Populist governments would be tempted to follow the Argentine example of blanket defaults, tired to ask their peoples for more sacrifices, this time because of U.S. policy failure.

After all, Argentina arguably “succeeded” in reneging on its obligations following a series of largely self-inflicted policy missteps. If U.S. pressures to revalue the yuan would lead to a scenario as described above ultimately resulting in double-digit interest rates, emerging markets would find it unaffordable to refinance their own debt obligations.

However, considering the cause for such inability to refinance, it would seem politically unpalatable to many emerging markets to impose further sacrifices on their populations to meet the demands of their creditors. Fairly widespread debt defaults might be the consequence.

Sluggish growth in Europe and Japan would also be snuffed out and the oversupply of low value-added products from China and other low-cost producers would fail to find a market.

Hence, we would have come full circle — and finally China would suffer the consequences of a global depression, while providing few permissible vents for impending social imbalance.

It goes without saying that this is a doomsday scenario of what might happen if Chinese authorities gave in to rising pressures and floated the yuan.

Over the last two millennia, the Chinese people have earned a reputation of wisdom and deliberation. One can only hope that they will live up to such high standards.