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The US won't fire its label gun

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1 The US won't fire its label gun on Sun Apr 18, 2010 5:09 pm

littlekracker


Sunday, April 18, 2010

The US won't fire its label gun


YUAN'S peg to the dollar helps the US currency from freefalling, and a gradual appreciation could be a long-term option. China still feels the pressure to revaluate the yuan although the United States has postponed the April 15 deadline for the Treasury Department to submit an annual report to the Congress.

Congressmen and women have signed a letter calling for the department to label China a currency manipulator. Nobel Prize laureate Paul Krugman has written in two of his New York Times columns that the US government must take the case to the World Trade Organization and, if China does not succumb, to wage a trade war with it. Other critics are advocating other countries to join the US in putting the heat on China.

Relax, everyone. The US Treasury will not label China a currency manipulator in its upcoming report. Why? The simplest way for the US Treasury to force China to revaluate its yuan is to sufficiently lower the interests paid on the Treasury bonds or to simply stop selling the bonds to China; the fact that it has yet to do so shows that it doesn't want a revaluation.

Let's see how this works. In order to peg the yuan to the dollar, the Chinese central bank has to buy large amounts of dollars. This, however, will release equally large amounts of yuan in China that will inevitably lead to inflation if left unimpeded by the central bank. In reality, the central bank issues interest-bearing bonds to offset the excessive money supply.

Now, if the US Treasury cuts the interest rate of its bonds below the rate paid on the Chinese central bank's offsetting bonds, the Chinese central bank will run a loss and may be forced to stop buying dollars. Once the sale of US Treasury bonds to China is halted, it will serve the same purpose and its effects will be more direct.

In fact, if the US stops selling its treasury bonds, a number of benefits could open up. First, as Krugman claimed, it prevents Chinese savings from depressing demand in the US. Second, it disciplines the US government in putting a clamp on its debt. Third, it does avoid a trade war that Krugman wanted. The inconvenient truth, however, is that the US Treasury needs cheap Chinese savings to finance a number of very urgent projects, such as its new healthcare plan.

It seems that some in the US want to have two good things simultaneously; an appreciation of the yuan and China's continuous supply of cheap money. This sounds like a deal too sweet to ask China to deliver.

But a more serious question is: Will revaluation help the US economy even if China is willing to do so? Probably not, at least not in terms of moderate appreciation. Between July 2005 and June 2008, the yuan appreciated against the dollar by 21 percent on nominal terms, but China's exports to the US still increased and trade surplus surged from $100 billion in 2005 to $300 billion in 2008.

A more drastic appreciation, say 20 percent as some would suggest, will likely have a strong effect, but that will also kill China's economic growth because exports were a strong growth factor between 2001 and 2008.

One fact that people often neglect is that the yuan is pegged only to the US dollar, so its under-valuation against other currencies, if it exists, is an automatic result of the US dollar's devaluation. That is, if the United States really wants to help other countries, it should not devalue its currency. The yuan's peg to the dollar, in a way, affects the whole world; it prevents a freefall of the dollar.

Depreciation of the dollar is a natural choice for the United States to adjust its economy, just like it did in the 1970s and 1980s, but it is at the expense of other countries. Therefore, other countries are not likely to join the US against China. In particular, the EU is engaged in a bitter fight over its own financial issues. While Germany runs large amounts of current account surpluses, other countries are deep in debt. The recent debates on Greece's bailout highlight the agony within the EU.

Krugman called for the US government to square up to China in a trade war because he believed that China would back down "precisely because the United States can get what it wants." He might be overly confident about his knowledge (or ignorance) of China by underestimating China's resolve when faced with a confrontation. From a purely academic point of view, Krugman has also failed one basic principle of a social scientist; looking at both sides when he thinks about a conflicting issue.

The exchange rate is ultimately a domestic issue. There is a trade-off between long-term economic growth and short-term macroeconomic stability. There are theories and empirical evidence showing that pegging to a major world currency provides an anchor for a developing country and accelerates its structural transformation. However, the peg also causes major macroeconomic problems. The central bank's offsetting policy is accumulating debts and can be a time-bomb of inflation if things go wrong in the future.

Balancing between long-term growth and short-term stability, a sensible approach is to adopt a manageable floating policy that allows the yuan to appreciate gradually, based on the gap of unit product costs between China and the US. Defending a completely fixed exchange rate is costly and corners China into dealing with other countries. Gradual appreciation is not a sign of weakness, but is in China's best interest.

2 Re: The US won't fire its label gun on Sun Apr 18, 2010 6:03 pm

Guest


Guest
The US won't fire its label gun<-----CHICKEN..oh wait china backed the US at the UN on iran sanction!!

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