Written by Jeff Thredgold, President, Thredgold Economic Associates
The U.S blinked in recent days, preferring to put off until after the November elections the question of whether or not to declare China a “currency manipulator.” Such a move might have been the correct one. What we don’t need at this juncture is a trade war with China.
The U.S.-China relationship is unlike any other on the planet. We need the Chinese to buy vast amounts of U.S. Treasury bills, notes, and bonds to help us fund our massive budget deficits. China needs the U.S. to be a major buyer of Chinese-produced goods.
Intense pressure upon China from the U.S., Japan, and Europe to allow its currency to strengthen further in value has been in place for years. The Chinese have allowed their currency, the yuan (also known as the renminbi) to rise in value roughly 20% versus the dollar since 2006, including a 2.8% rise since mid-June 2010.
Critics of China strongly argue that another 20% or 30% or even 40% appreciation is needed to better “balance” the global economy, reduce Chinese exports to the world, and enhance Chinese demand for additional exports from the U.S. and other nations.
U.S. and other major nation manufacturers have a valid claim that the efforts of the Chinese leadership to keep its currency undervalued allow China to sell more products around the globe, thereby undermining (and under pricing) manufacturers in the U.S. and around the world…no argument here.
The Chinese are a proud people. Their leadership has made it clear that additional currency appreciation will come, but it will be on their timetable…not ours.
The Flip Side
However, there is an important and positive by-product of that undervalued yuan. Goods produced in China are more affordable to Americans, whether shopping at Wal-Mart or Target or Forever 21 or other retailers. The Chinese currency manipulation allows greater U.S. household purchasing power for Chinese-made goods…good news for U.S. households that are already under tremendous pressure from a very damaging recession and a weak U.S. economic recovery.
Record imports from China have led politicians from both sides to demand a stronger yuan. The roughly $28 billion U.S.-China trade imbalance in August ($35 billion in U.S. imports, versus $7 billion in U.S. exports) recently provided more ammunition for the appreciation argument.
China is easily our fastest growing export market. China is now the third largest export market of the U.S.—behind only Canada and Mexico. From 2000 to 2009, U.S. exports to China surged 330%, while U.S. exports to the rest of the world rose only 29% (USA TODAY).
The Chinese bought $21.7 billion of U.S. Treasury securities in August, bringing its total ownership to $868.4 billion. Japan ranks second with $836.6 billion of U.S. Treasury securities (money.CNN.com.)
Down the Road
Chinese premier Wen Jiabao talked candidly about the currency earlier this month, noting “if we increase the yuan by 20-40 percent as some people are calling for, many of our factories will shut down, and society will be in turmoil.” He noted that would be “a disaster for China and the world.” Rarely has a Chinese leader been so candid about societal and political challenges in this nation of 1.3 billion people.
What he may not see are the longer-term benefits to China of a stronger currency…less global friction, stronger Chinese consumer purchasing power, and less dependence upon volatile exports to the global community
The Premise…sometimes clairvoyant Adilyn saw a brief glimpse of the future, five years hence
The Setting…having dinner with some intellectual friends
“Trust me!” Stated Adilyn to her skeptical friends, “I really did see a glimpse of the economy and financial markets five years from now.”
“No Way!” Stated Kennadie, sitting to Adi’s left.
“I did. The government just ran a $1.3 trillion annual budget deficit, following a $1.4 trillion deficit the year before.”
“OK,” noted Kennadie, “if the deficit were ever that enormous, intermediate and long-term interest rates would have to be at extremely high levels in order to attract all of the buyers necessary of U.S. Treasury notes and bonds to fund that deficit. Such high interest rates would likely kill any economic recovery.”
“Actually,” noted Adi, “10-year maturity U.S. Treasury notes are around 2.50% and 30-year fixed-rate conventional mortgages are around 4.25%, at or near the lowest levels in 50 years.”
“No Way!” Stated Ella, sitting to Adi’s right. “That relationship of enormous deficits and extremely low long-term interest rates makes no sense. It would also seem logical that if budget deficits are that out of control, the Federal Reserve must be pushing its key interest rate higher in order to stifle impending inflationary pressures.”
“Well actually,” noted Adi, “the federal funds rate has been at 0.00%-0.25% for nearly two years, the lowest level ever. In addition, the Fed is likely to buy roughly $500 billion or more of mortgage-backed securities and U.S. Treasury securities in coming months to help the economy. These purchases would be in addition to roughly $2,000,000,000,000 of similar purchases during the past two years.”
“No Way!” Stated Kennadie and Ella simultaneously. “First of all, such enormous purchases, all financed with money created out of thin air, would force inflation expectations higher and higher. The Fed would be viewed to have lost its collective mind.”
“Actually,” stated Adilyn, knowing that further disbelief was imminent, “consumer prices have risen only 1.1% during the most recent 12-month period. In addition, ‘core’ inflation, excluding food and energy prices, has risen only 0.8% during the past year, the smallest rise in 49 years.”
“No Way!” Stated her now clearly exasperated dinner partners. “OK, how ‘bout this. With that level of government stimulus and that level of monetary stimulus, the economy must be booming. Home prices must be surging. The unemployment rate must be extremely low. How could it not be with such unprecedented—and frankly unbelievable—stimulus?”
“Well actually,” stated Adi, “the economy is barely growing, with a meager 1.7% real (after inflation) growth rate during 2010’s second quarter and similar growth expected during the third quarter. Average home prices have fallen roughly 30% over the past three years. In addition, the unemployment rate is at 9.6%, and has been at 9.5% or higher for 14 months, the longest such period since the Great Depression.”
“No Way!!” Shouted Kennadie. “That combination of factors simply makes no sense.”
“Here’s an idea,” Ella continued. “You’re a good friend. But next time you have one of your clairvoyant episodes, please keep it to yourself.”