U.S. Treasury to China – Revalue Remnimbi or We Will

There’s a lot of talk around the markets and in Washington about China’s currency policy. What many want to know is whether the US Treasury will name China as a currency manipulator. Perhaps a more important question is, should China be named as a currency manipulator? And if it were named as such, what actions could the US take? In recent days the Chinese and the US administration have taken shots in the press at each other. The US is hinting that China is manipulating its currency to boost its economy. The Chinese is firing back saying that the US “should not politicize the remnimbi exchange rate issue.”

First, some background on the problem. Basic economics says that if you keep the currency of your country at a weak (but not so weak as to cause a collapse in it) level you help boost exports. The currency becomes weaker making your goods cheaper for foreign consumption. In a freely floating exchange system, the market determines the equilibrium value. Speculators look at economic statistics like GDP growth, interest rates, inflation etc. to figure out what a currency should be worth and then place bets accordingly. If speculators think that an economy can grow strongly while keeping inflation at a benign rate, they will bid up the currency of that economy. As that happens, the country whose currency is getting stronger could see a decrease in exports. This is caused by the larger amount of currency the importer uses to make the same purchase as previously made.

Here is China’s problem. It has an economy growing rapidly (the number bandied about is 10%, but who really knows the number?) and it has capital that continues to enter the country. China has a large population of around 1.2 billion many of whom are trying to move to a higher economic level. If China lets its currency the Remnimbi appreciate in the market place, its economy could grow less robustly. To prevent this from happening, China pegs the Remnimbi to the dollar at an exchange rate it deems acceptable (translation: low). I am not exactly sure how it accomplishes this but I would guess that it declares publicly that the rate of such and such is the exchange rate and then intervenes in the exchange rate markets to keep it in line. Currently, the peg is kept low which helps China’s exports boom keeping its economy strong.

In normal times, this might not be such a bad arrangement as it helps keep a lid on prices in the US and therefore inflation. However, these are not normal times in the US. The economy and financial system have been through a massive shock. US GDP has not been able to grow without large stimulus injected through Federal Reserve quantitative easing and through fiscal stimulus. The US unemployment rate (which is what gets US politicians juices flowing) has been stubborn at around 10%. These factors have made China’s currency policy something that US officials are taking aim at. With the Fed scheduled to end its quantitative easing soon, the economy will have less of a tail wind behind it making China even a larger target.

So, what can the US and the Treasury do? It could label China a currency manipulator. Eventually it could take forceful action and even slap tariffs on Chinese exports to the US. This solution was written about by Paul Krugman in the NY Times in recent days. This solution though could lead to a trade war and offers glimpses of what happened during the Great Depression following the unleashing of the Smoot Hawley act. The tariff war that followed shut down trade and led to a global collapse in world exports exacerbating the Great Depression. What else could the US do? If the US truly believes it would benefit from a stronger Remnimbi and a weaker US dollar, it could take action in a similar fashion that China has. It could declare an exchange rate it deems acceptable and then intervene in the currency markets to enforce this band (translation: cheaper dollar, stronger Remnimbi). China would have trouble bashing this policy as this is its strategy. The US GDP growth would benefit from higher exports to China. It would also help other countries who have problems with China’s US dollar peg.

There are problems with this solution too though. First, the US would be guilty of currency manipulation. Second, the weaker dollar could lead to higher US inflation as Chinese goods become more expensive. Lastly, it could tick the Chinese off so much that they take some retaliatory action. But if the US feels that the US economy would benefit from an exchange rate more favorable to US exports perhaps this could be looked at. Or, it could just be used as saber rattling to tell the Chinese that the US is serious about what it perceives as a serious disadvantage to its economy.

Authored by Tom Henderson, Strategist JBH Capital.

Disclosure: There are no disclosures to make.