The House Ways and Means Committee has just approved a bill that would attempt, albeit modestly, to crack down on Chinese currency manipulation, a key cause of America's trade deficit. The Ryan-Murphy currency bill (HR 2378) would allow the Commerce Department to treat currency manipulation as an illegal subsidy for the purpose of calculating countervailing duties intended as retaliation. This bill has to be passed by the full House of Representatives and then the Senate before becoming effective, but already the prophets of doom are squealing about the dangers of starting a trade war with China. They are wrong.
How does China manipulate its currency? Mainly by preventing its exporters from using the dollars they earn as they wish. Instead, they are required to swap them for domestic currency at China's central bank, which then "sterilizes" them by spending them on U.S. Treasury securities (and increasingly other, higher-yielding, investments) rather than U.S. goods. As a result, the price of dollars is propped up -- which means the price of yuan is pushed down -- by a demand for dollars which doesn't involve buying American exports.
The amounts involved are astronomical: China's accumulated dollar-denominated holdings amount to $2.4 trillion, an astonishing 40 percent of China's GDP. The China Currency Coalition estimated in 2005 that the yuan was undervalued by 40 percent; past scholarly estimates have ranged from 10 to 75 percent. China has in the past allowed token appreciation of the yuan, but nothing serious. As a result, China is now responsible for 83 percent of America's non-oil trade deficit.
Doomsayers argue that American retaliatory tariffs on Chinese exports would be met by Chinese tariffs on our own exports, producing a cycle of retaliation that would choke off trade between the two nations. It is an easy disaster scenario to imagine, especially if one believes the utter myth that such a cycle is what happened during the Great Depression due to the Smoot-Hawley tariff of 1930. But this is actually unlikely, for a number of reasons.
For a start, there is the fundamental fact that China is unlikely to engage in catastrophic escalation because they, not we, are running the surplus, so they are the ones with something to lose. (China's exports to the U.S. are more than four times America's exports to China.) The only way a deficit nation can "lose" a trade war is by having its trade balance get even worse. Given that the U.S. trade balance is already outlandish, it is hard to see how this could happen.
Of course, China has other cards up its sleeve, like threatening to dump its massive dollar reserves. But doing so would carry enormous costs for Beijing. For a start, beginning to sell these reserves would reduce the value of the large reserves they would still be holding. Furthermore, this would depress the value of the dollar -- exactly the opposite of their currency manipulation strategy. Then there is the awkward problem of what China would do with all the money it would get by selling off its dollars. There just aren't that many good alternatives for parking that much money. The Japanese don't want their currency used as an international reserve currency (and will stymie anyone who tries), and the Euro has huge problems of its own right now. Assets like gold and minor currencies are volatile or in limited supply. Other assets, like American or European real estate or corporate stocks, are, by definition, denominated in dollars or euros, so this wouldn't get around the currency problem.
Similarly, China could threaten to stop buying U.S. Treasury debt (which would spike American interest rates), but is constrained by the fact that this would reduce the value of the $840 billion or so that it already holds. This action would also lower the price of the dollar by abandoning China's key lever for pushing it up. Furthermore, the U.S. could retaliate by revoking the tax exemption of interest on foreign-held Treasury debt, established in 1984 by Treasury Secretary Donald Regan. (As a true hypothetical doomsday scenario, we could even suspend interest payments on the debt, though this would be irresponsibly disruptive and is thus extremely unlikely in peacetime.)
The fundamental reality is that the United States is already in a trade war with China. In the real world, as opposed to the fantasy of laissez faire economics, international trade is adversarial. This doesn't mean that there aren't win-win aspects to it -- there are -- but it does mean that there are enough win-lose aspects to it that nations need to actively defend their own economic interests. This active defense is known as "mercantilism," and it is a game China has been playing for decades now while the U.S. pretends the game doesn't even exist. (Ironically, the U.S. was itself founded as a mercantilist country, though we've forgotten.)
Right now, America is in an economic war of attrition with China, in which our enormous trade deficit inexorably, year by year, has two effects: first, it reduces America's net worth by piling up debt and selling off American assets, and second, it grinds down America's industrial base by driving American companies out of business. If America does nothing, we will remain stuck in this war, and will continue to lose it. This is a costly outcome in its own right for the U.S., and its cost must be weighed against any imagined dangers of a trade war.
It is inevitable that the present trading relationship between the U.S. and China cannot go on forever. At some point, America's ability to run gigantic deficits must end due to a prolonged slide or sudden crash in the value of the dollar. Unless God or Santa intervene to prop up the dollar by giving America free imports forever, an end to the current imbalance will come -- whether we or the Chinese want it to or not. But the longer we wait for this inevitable readjustment of currencies to basic economic laws of gravity, the more traumatic the adjustment will be.
The longer we wait, the bigger the decline in the dollar and the greater the likelihood that it will come as a sudden and destabilizing shock, rather than a managed, more gradual adjustment. It follows that those who are trying to avoid doing anything on U.S.-China currency problems are merely postponing, by a few years at best, the inevitable and making it worse when it finally comes. This is the height of irresponsibility, and it is therefore they, not we who would begin to deal with these problems now, before they have the chance to get any bigger, who are risking economic debacle. Kowtowing to China today is economic appeasement, and involves the same equation as political appeasement did in the 1930s: a few more years of relative quiet with a bigger explosion at the end.
Furthermore, this issue is bigger than China alone. How America deals with Chinese currency manipulation will set the precedent, and establish or destroy America's credibility, for dealing with a long list of other nations that have been playing currency games. China is merely the most blatant and politically sensitive case. For example, Japan has recently moved to weaken the yen to preserve its competitiveness, and Brazil has talked about weakening the real. Singapore, Taiwan, and Malaysia and Indonesia have also been identified as currency manipulators. Germany continues to enjoy an underpriced currency by being on the euro, a "blended" currency that is too strong for the weaker economies in the EU and too weak for the stronger ones.
Strong action now on all foreign predatory practices, including currency manipulation, is the order of the day. Congress should stop listening to the alarmists before the alarm bell really rings on America's economic future.
Ian Fletcher is the author of Free Trade Doesn't Work: What Should Replace It and Why (USBIC, 2010, $24.95) An Adjunct Fellow at the San Francisco office of the U.S. Business and Industry Council, a Washington think tank founded in 1933, he was previously an economist in private practice, mostly serving hedge funds and private equity firms. He may be contacted at ian.fletcher@usbic.net.
Thank you for explaining the "sterilization" process. It shatters the arguments that pro-China types have of Uncle Sam with his hands out, begging a China panda for money.
China isn't "lending" us money, they're manipulating their currency, and using the least beneficial way they can... buy US financial assets, instead of investing in US infrastructure or business.
Thanks again for this article.
Unlike Japan, China does not engage in open market purchases - there IS NO OPEN MARKET where they can actually use RMB to buy Dollars to lower the value of the RMB.
The accumulation of trade dollars in the hands of the China central bank comes from the natural process mandated by law. Just like in the U.S., foreign currencies cannot be used locally. So when an exporter from China collects payment in US dollars, those cannot be used inside China. Of course they can be used to pay for imports (to buy materials, machines, etc.) By law the importer has to exchange the excess (net of imports) into RMB in order to continue doing business - to pay rents and other expenses, such as workers' salaries. This legally mandated exchange (central bank issue more RMB to the importers in exchange for their excess dollars) is the principal way that the China central bank acquired the dollar reserves.
Since the Chinese believe in savings (40% savings rate) and disfavor consumption, imports ARE less than exports. Thus the reserves increase over the years.
Since there is little or no opportunity to buy dollars on the open market using RMB, there CANNOT be manipulation. The Chinese just don't like to spend all their money on consumption. The amount of reserves is governed by HOW MUCH IMPORTS AMERICANS CHOOSE TO BUY.
I think the point is that when the exporters exchanger their dollars it is at a controlled rate instead of a floating rate. Am I wrong too?
I don't have much hope when I hear that the GOP filibustered a bill to close loopholes that give companies an incentive to offshore jobs. Of course that vote was, yet again, for the good of the party not the good of the country.
Just look at what happened to tires in the 1 year (since 2009) that the 35% tariff was imposed on Made in China tires. Prices of the tariffed tires went up more than 25% (at least $50 higher per set of 4 tires). Even the prices of non-tariffed tires went up 10-20%. But imports did not go down - they went UP 21%, showing that there was shift of purchases to other low cost supplier nations, but apparently not low enough, as prices went up. Worse yet, instead of producing jobs, Dept. of Labor figures for the first 6 months of 2010 showed a 10% DROP in tire manufacturing in the U.S., YOY. This is not even counting the loss of demand due to higher prices, which likely killed more retail jobs.
Working class folks lose all around as a result of protectionism - higher prices, fewer jobs.
Mr. Fletcher can explain the theory and cause/effect much better than me (and you?). I hope you will read his book or at least his other posts and see that he makes some very good points in a very reasoned way.
When a Chinese exporter sells for dollars, by law those dollars CANNOT be used in China (just as no foreign currency can be used inside America - not without changing them to US Dollars first). The China exporters would perforce and by law have to exchange the US Dollars at the China central bank for RMB, which they can then use to pay rents and other expenses, such as employee salaries. They can of course also use the US Dollars for imports, so the central bank gets only the NET amount of exports minus imports in US Dollars.
Therefore the amount of US Dollars in the reserves are largely determined (since there is very little open market purchases) by HOW MUCH IMPORTS AMERICANS CHOOSE TO BUY.
How can that be manipulation?
Just draft a law requiring ALL consumer electronics
imported into the United States must provide at the very minimum,
a 5 year replacement warranty.
Of course then foreign nations would require American products
to be covered equally.
http://noir.bloomberg.com/apps/news?pid=20601087&sid=a8pn5LxRIvUs&pos=1
Geithner Says No Threat of China Trade War or Currency Wars - Bloomberg.com
" Sept. 30 (Bloomberg) -- U.S. Treasury Secretary Timothy F. Geithner today said he was confident tensions over China’s currency, the yuan, won’t lead to escalating trade sanctions or feed into a broader global currency conflict.
“We’re not going to have a trade war,” Geithner said in remarks to a Washington conference hosted by The Atlantic magazine and the Aspen Institute.
The U.S. House of Representatives this week approved a bill that would let companies petition for duties on imports from China to compensate for the effect of an undervalued yuan. Also this week, Brazilian Finance Minister Guido Mantega warned of a global “currency war” as his country weighs a higher tax on capital inflows.
Geithner said today he wasn’t sure “what that means” to talk about a “currency war.” In any case, he said, “we’re not going to have currency wars..."
Who would win in a trade war?
"In a report on rare earth materials in April, the Government Accountability Office said rebuilding the US rare earth supply chain could take up to 15 years and is dependent on several factors, including securing capital investments in processing infrastructure, developing new technologies, and acquiring patents - many of which are currently held by international companies, the GAO stated.
The report went on to say the US has the expertise but lacks the manufacturing facilities to refine oxides to metals. For example, the US is not currently producing neodymium iron boron (NeFeB) permanent magnets used for computer hard drives and cell phones and has only one samarium cobalt (SmCo) magnet producer. SmCo is used a lot in what's known as a traveling-wave tube, an electronic device that amplifies radio signals.
The GAO says one existing mine, the Mountain Pass mine in California, could be fully operational by 2012. Although the Mountain Pass mine is the largest non-Chinese rare earth deposit in the world, the mine currently lacks the manufacturing assets and facilities to process the rare earth ore into finished components, such as permanent magnets. The mine also does not have substantial amounts of heavy rare earth elements, such as dysprosium, which provide much of the heat-resistant qualities of permanent magnets used in many industry and defense applications, the GAO noted."
DO fear a trade war with China..cuz we have been in a trade war with China fro at least a decade (what else could artificially keeping the value of the Renminbi low be called ? ),,and we are getting our rear ends handed to us.
Tariffs are the response the market calls for in the face of currency manipulation.
Comparing China to the Middle East either shows you know nothing about China or nothing about the Middle east, or both.
http://www.manufacturingnews.com/news/10/0518/chinadrugs.html
You Don't Know Where Your Drugs Come From And Neither Does The FDA; U.S. Imports 90 Percent Of Its Antibiotics (And Vitamin A) From China
"...The United States needs two tons of heparin per month. Seventy percent of that is sourced from China, says the study. Tainted Chinese heparin (made from pig intestines and used as a blood thinner) supplied to Baxter International caused the death of 81 Americans in early 2008. After a fall-off of heparin exports in 2008, "the situation has changed in 2009," says the study. "Heparin exports for the first quarter of 2009 increased 155 percent compared to the first quarter of 2008. The price of heparin also doubled (to $4,354 per kilogram) in the first quarter of 2009."
China accounted for 61 percent of all ibuprofen sold into the U.S. market in 2008, with its product used in Advil, Aleve and Motrin, among others. More than 90 percent of the tetracycline supplied to the United States and used in most antibiotics is now supplied from China..."
Here's the last Communist Chinese import anyone would ever use:
http://www.onesourcechina.com/
Import Caskets from China for Thousands Less Than What US Manufacturers Charge
Just imagine how fast Congress would reinstate usury laws.
http://www.whatdoesitmean.com/index1409.htm