Spring has Spring but No Thaw in US-China Relations

The US political pressure on China will heat up in the coming weeks. The pressure will likely culminate in May with the US Treasury formally citing China as a manipulator in the currency market. Anticipation of further appreciation of China’s renminbi is likely to help underpin other currencies in the region and help draw investment into the regional equity markets.

Ironically, but not coincidentally, the heightened pressure that will be brought to bear on China will take place as the renminbi’s appreciation has accelerated. In the first couple months of after the revaluation and shift to a basket approach, the yuan hardly moved against the dollar. In November 05 through January 06, the dollar fell about 0.1 renminbi a month. The pace doubled in February and quickened further in March with roughly a 0.3 renminbi move since the middle of the month.

That said, one needs to keep the renminbi’s advance in perspective. It has appreciated a largely inconsequential 0.66% against the US dollar in Q1. Although this is more than the 0.18% the Japanese yen appreciated, it pales in comparison to the appreciation of other currencies in the region, like Indonesia’s rupiah’s 8.4% gain and Thai bhat’s 5.6% gain, and the Philippine peso and South Korean won’s 4% appreciation. But not only has China gained currency competitiveness against its regional trading partners, but unlike H2 05, the renminbi lost ground against the European currencies, including the euro and British pound.

The fact that the renminbi has depreciated against most currencies in Q1, despite its acceleration albeit minor appreciation against the dollar, may encourage others to support the pressure the US is exerting.

There are many international forums in the coming weeks and each will likely see the issue of China’s integration in the world economy being discussed. The first week of April will likely see more official rhetoric and positioning ahead of a number of events later in the month, beginning the following week.

The first such event is a central bankers meeting in Vienna on April 8-9. Deputy finance ministers and sherpas meeting that will lay the groundwork for the formal G8 meeting later in the month. The next event is on April 11, when the US-China joint commission on commerce and trade meets. This comes on the heels of the US and EU decision to jointly challenge China’s tariff on foreign auto parts. For all the complaints and hand wringing, this is only the US second WTO challenge of a PRC practice and the first by the EU.

This will be followed on April 19-21 by the first WTO members meeting formally review China’s trade policy. China’s President Hu is scheduled to visit the US on April 20. There is a G8 meeting on April 22. The agenda of the meeting has yet to be agreed upon but official comments suggest that there will be several issues to be discussed. These include, a discussion of the impact on credit tightening in the major economies, a discussion of oil prices, bird flu and, most important in this context, global imbalances. In his recent speech in New York, Federal Reserve Chairman Ben Bernanke acknowledged that the major countries recognize that the US current account deficit is only one dimension of the global imbalances and that the agreed upon efforts to address those imbalances have been modest at best. The agreed upon solution is not predicated on a dollar depreciation. Rather it focuses on structural reforms. The US is to boost savings. Europe and Japan are to boost domestic demand. Asia is to make introduce greater flexibility into their capital markets and currencies.

There is no sign that the major industrialized countries are going to abandon this program even though it has yet to be fully implemented. There are a few commentators who have suggested that the meeting may produce a mini-Plaza like agreement to drive the dollar lower. Rumors in recent days that the US was about to abandon its strong dollar policy played into such talk, but once again proved unfounded.

Ronald Reagan once explained that one of the consequences of his administrations saddling the US with a great deal of debt was that the Democrats would not be able to spend like the used to. Robert Rubin essentially took a page out of Reagan’s play book by giving the US a strong dollar policy. No US Treasury Secretary can do what say James Baker or Lloyd Bentsen did of using the US dollar as a weapon in trade negotiations (the former with Germany the latter with Japan) without risking a destabilizing run on the greenback.

It is true that while Rubin and his immediate successor, Lawrence Summers, are given credit as the architects of the strong dollar policy, they both authorized intervention once during their tenure (after 1995) and both were to sell dollars. Rubin authorized the selling of dollars against the yen in 1998 along side Japanese authorities. Summers authorized the selling of dollars against the euro in a coordinated effort with the ECB and others in the fall of 2000.

Nevertheless, the strong dollar policy has significant meaning. If one doubts this, just consider what would happen if a US Treasury Secretary said that the US no longer believed that a strong dollar was its interest.

No one really wants this. It would risk cutting short the nascent recoveries in Europe and Japan. Insofar as US rates would rise quickly, it would put the US economy at risk as well. And for what? There is no guarantee that a weaker dollar or weaker US growth will significantly reduce the US current account deficit in a sustained fashion. The improvement in the US current account deficit for a few years around 1990 was a function of the US economic downturn and the fact that the first Gulf War was financed by other countries. The recession in 2001 did not see the US external deficit improve.

Lastly, consider that much of the US rhetoric is posturing. The Bush Administration wants to head off more protectionist action from Congress. There seems to be an informal quid pro quo. Senators Schumer and Graham again postponed their punitive bill (until September, at least) and the Treasury officials have escalated their rhetoric and pressure on China. Both Treasury Secretary Snow and the under-Secretary Adams claimed in recent weeks that China could adopt a more flexibly currency regime, that the institutional framework exists, but what is lacking is political will. In the newly released national security strategy the renminbi’s value was identified as a security issue. There is little doubt after a respectable period of time after President Hu visits the US, the Treasury Department will cite China as a currency manipulator.

China of course will protest such a designation. How can a peg—which is no longer a peg, be considered manipulation ? The renminbi was pegged to the US dollar when the dollar was strong in the second half of the 1990s and when the dollar was weak as in the last half decade. That is the beauty, if you will of the Grassley-Baucus bill that would shift the focus from currency market manipulation to currency misalignment.

But misalignment begs the question, what is the appropriate value and who determines it? For the all the lip-service paid to the benefits of exchange rates being determined by market forces, many US and Japanese officials would be content with a sharp appreciation of the renminbi and allow the China to then develop a more market based exchange rate policy at its own leisure.

After all markets are a little like a democracy. Once in place, it is hard to control the outcome. Similarly, letting the renminbi float with open capital markets could very well see the renminbi fall. The hot money betting on a revaluation would take their money out and look for another play. International businesses which account for about half of China’s manufacturing exports would find it easier to repatriate their earnings from China. In addition, the growing economic elites, like the elites in other developing countries would likely take some of their wealth and put it offshore.

China is likely to announce a wider band for the renminbi against the dollar. Currently it is allowed to move in a 0.3% band. Remember under Bretton Woods, a 1% band was regarded as fixed. And even that 0.3% band is not being fully explored. Therefore widening the band to say 2.5% or 3% would be a low cost concession for China, especially if only a small part of the new band is explored.