IS IT THE ULTIMATE CURRENCY WAR?
AMERICA AND CHINA ARE AT LOGGERHEADS
WHAT IS THE STORY BEHIND THE STORY?
Rama Krishna Vadlamudi April 16, 2010
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The controversy surrounding the revaluation of Chinese currency Yuan has occupied the attention of the market players and politicians in the last few months. The million-dollar question is: will they or won't they – meaning whether China will allow its currency to appreciate against the US dollar?
Two weeks back, American Treasury Secretary Tim Geithner postponed releasing a Currency Report. It was expected that this report would have dubbed China as a ‘currency manipulator’ – triggering a trade war between China and America. Such a trade war would have adverse implications for the world trade and would send shock waves across the global financial markets. So, what are the chances of such a panic reaction from the markets happening in the next few quarters? Let us try to examine the issue in detail:
THE SPAT BETWEEN PAUL KRUGMAN AND STEPHEN ROACH
China has kept the Yuan stable against the dollar since September 2008, when Lehman Brothers collapse caused havoc in the financial markets across the globe. Many Americans, including Nobel laureate in economics Paul Krugman, believe that America should pressurize China to appreciate the Yuan. Those in this ‘hard line’ camp argue that China is causing a lot of damage to the world trade (read it as American economy) by keeping the Yuan pegged to the dollar constantly. A few months back, a Reuters’ Survey had put the undervaluation of Yuan at around 20 per cent, meaning Yuan should have moved from the present 6.83 to around 5.50 per dollar had China not halted its appreciation in September 2008 post-Lehman Brothers collapse.
However, there are others who believe that America alone is responsible for its twin deficits - both trade and fiscal. A respected financial expert Stephen Roach, Morgan Stanley Asia chairman, argues that America should mind its own business rather than blaming China for the woes of their own-making. He openly crossed swords with Paul Krugman recently about the American strategy on Yuan revaluation. A big problem for America is its lack of competitiveness.
If Yuan appreciates against the dollar, it will make Chinese exports to America costlier. And this may help bridge the big trade deficit America has with China in a limited way. America has got its own problems. For example, it has got huge fiscal and trade deficits. And Chinese exchange rate policy is not responsible for American mess which is self-created. Another thing is America is not a nation of savers, like, Japan or Germany. Till recently, Americans had negative savings. After the global financial meltdown, there is some upturn in savings from American households.
CHINA IS WORLD’s FACTORY:
China is a global manufacturing factory and is heavily dependent on its exports. Any adverse impact on its exports will undermine its labour markets. China has to protect its domestic economy from the ill-effects of the global financial meltdown. China’s first priority is to protect the jobs of its domestic workers, in an effort to “maximize export employment.” So, it has been playing very hard with its currency by not allowing any appreciation against the US dollar. However, this has earned the wrath of many of its trading partners.
China has been enjoying huge trade surpluses (exports much higher than imports) for several years. As a result of its long-running trade surplus, China amassed huge foreign exchange reserves, which are at USD 2.45 trillion as at the end of March 2010 making China the world’s biggest holder of foreign exchange reserves. In Indian rupee terms, China’s reserves are at Rs 109 lakh crore or almost nine times that of India’s reserves. India’s latest figures show their foreign exchange reserves at Rs 12.4 lakh crore or USD 280 billion. (1 trillion = 1,000 billion or one lakh crore)
Paradoxically, out of this massive foreign exchange reserves of USD 2.45 trillion, China has invested around USD 900 billion in US Government securities (or US Treasurys). It is in the interest of both America and China not to escalate the current controversy into a full-blown trade war. A trade war does not do any good to either country. So, in the interest of world trade, these two countries shall desist from any hawkish approach and try to look for some ‘soft’ approach in resolving the current currency row.
CHINA EASED ITS CURRENCY POLICY IN JULY 2005
China eased its currency policy in July 2005. At that time, their central bank, the People’s Bank of China, made it clear that it would ‘ease’ but not abandon its traditional peg to the dollar. It had allowed a managed float for Yuan against a basket of currencies of countries with which it trades. In July 2005, one US dollar was fetching around 8.30 Yuan. With its managed float stance, the Yuan is quoting at around 6.83 to the dollar now – indicating an 18 per cent appreciation of Yuan against the dollar between July 2005 and September 2008.
Since the middle of September 2008, China reverted back to its traditional peg to the US dollar. Many other Asian countries, including India, have allowed two-way movement of their national currencies against the US dollar despite their own economic problems.
JOSEPH STIGLITZ: No time for trade war
“Saudi Arabia’s trade surplus of USD 212 billion (11.5% of its GDP) in 2008 dwarfs China’s USD 175 billion surplus (5% of its GDP), as a percentage of GDP. China’s current account surplus is actually less than that of Japan and Germany (5.2% of GDP). Then, why blame China alone for American deficits?”
Thus said Joseph Stiglitz, Nobel Prize winner of economics, in an article published in Economic Times dated April 16, 2010
CHINA AND AMERICA: SIAMESE TWINS?
The dollar has appreciated by about 10 per cent against major currencies in the last five months easing the Chinese concerns on the safety of their investments in US Treasurys. On its part, China needs to reorient and rebalance its economy from export-driven to domestic consumption-led, like the way India has been doing now. All indications at this point of time show that in the next year China would definitely allow Yuan’s appreciation of around 4 to 6 per cent with a caveat that they would do it at their own pace and convenience.
If America and China decide to go for a full-blown trade war, this would have disastrous consequences for world trade – which would send the stock markets into a jittery phase and the indices may fall sharply in a matter of few days if not hours.
Picture courtesy: PBOC, US Treasury
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