Why the world is nervous about trade tensions between China and the US: Maley

Global share markets were shaken overnight by fears that simmering trade tensions between the United States and China could be about to boil over.

In the United States, the Obama administration is being pushed to take a tougher line with China over its artificially low currency, which hurts US producers and workers. Overnight, a bipartisan group of 130 members of the US House of Representatives fired off a letter to the Obama administration, urging it to force China to stop manipulating its currency, including slapping tariffs on Chinese imports if the Chinese failed to respond.

“The impact of China’s currency manipulation on the US economy cannot be overstated,” it said. “Maintaining its currency at a devalued exchange rate provides a subsidy to Chinese companies and unfairly disadvantages foreign competitors.”

The letter, sent to US Treasury Secretary Timothy Geithner and Commerce Secretary Gary Locke – also demanded the Treasury department formally label China as a currency manipulator in its mid-April report.

The US reaction comes a day after Chinese Premier Wen Jiabao claimed the yuan was not undervalued and issued a blunt warning to the US to stop trying to force China to let its exchange rate rise. China, he said, opposed “all countries engaging in mutual finger-pointing or taking strong measures to force other nations to appreciate their currencies”.

He also went on the attack: “What I don’t understand is depreciating one’s own currency, and attempting to pressure others to appreciate, for the purpose of increasing exports. In my view, that is trade protectionism,” he said.

But the Chinese Premier’s strong words misjudged the US mood. Faced with sluggish economic growth, and large pools of unemployed workers, US patience with China is wearing thin.

Nobel prize winning economist, Paul Krugman pointed out in his New York Times column earlier this week that there have been widespread allegations that China was keeping its currency artificially low order to boost its exports since about 2003.

At that stage, China was adding about $10 billion a month to its reserves, and its current account surplus was $46 billion. But China’s surplus has now ballooned to the point where the country is adding more than $30 billion a month to its $2.4 trillion hoard of reserves. And the International Monetary Fund expects that China will have a current account surplus of $450 billion this year. As Krugman notes, “this is the most distortionary exchange rate policy any major nation has ever followed”.

What’s more, he argues, “it’s a policy that seriously damages the rest of the world”. Most major economies are struggling with sluggish economic activity, but they can’t cut interest rates to give the economy a boost because interest rates are already close to zero. China’s big trade surplus, he says, amounts to an “anti-stimulus” on these economies, one that they can’t offset.

Krugman argues the US Treasury should finally identify China as a currency manipulator in its mid-April report. If China digs in and refuses to let its currency appreciate, he says the US should impose a hefty 25 per cent import surcharge on Chinese imports.

But what about worries that China will retaliate to tough US moves by dumping US assets? After all, more than two-thirds of China’s $2.4 trillion in reserves are estimated to be in US dollar denominated assets?

Krugman argues that if China did try to sell off a large chunk of its US assets, short term interest rates wouldn’t change. Long-term interest rates, he says, might rise slightly, but the US Fed could increase its own purchases of long-term bonds to offset the effect of Chinese selling.

The biggest impact, he argues, would be on the value of the US dollar, which would fall against other major currencies such as the euro. But that would be good for the US, making its exports more competitive and reducing its trade deficit. And it would be bad for China, which would suffer a large drop in the value of its remaining US investments.

It will be tempting for China to dismiss these increasingly vehement threats from the US as mere rhetoric – after all, China has withstood bouts of US dissatisfaction over its exchange rate policies for the past seven years.

But this would be a highly risky strategy. The US is now convinced that China’s artificially low currency is jeopardising its economic recovery. This time the US will likely follow up its threats with trade sanctions.

This article first appeared on Business Spectator.