China and Currency Manipulation

Posted by Jeff Carter
on January 17th, 2011

The Senate is full of bluster over Chinese President Hu Jintao’s visit. The reliably populist Charlie Schumer said,

“There’s no bigger step we can take to preserve the American dream and promote job creation, particularly in the manufacturing sector … than to confront China’s manipulation of its currency.”

The message to Hu is “we are fed up with your government’s intransigence on currency manipulation. If you refuse to play by the same rules, we will force you to do so,” Schumer said in a conference call with reporters.

Sorry Charlie. The Senate did more to wreck the American dream in the past two years than China has. I think they call that shooting yourself in the foot.

Let’s assume Finance expert Charlie Schumer gets his way. China lets their currency float. What would the expected fall out be?

First move would be the value of the yuan would rise significantly. It’s doubtful that it would be worth more than a US dollar, but it might be worth Currently, the peg is $7.75-$7.85 to one US dollar. It’s hard to put an exact number on where it would go, but lets say initially it rises by half. $3.40 to one dollar.

Ask yourself a question, where does America buy most of it’s goods? If you said China, you were right. Everything that you buy from China just doubled in price. I think they call that hyper inflation. Are you ready for that?

Good because it gets worse.

Americans own the lion’s share of their own debt, but China owns a large percentage of it. They have no choice except to buy our debt as long as they are reliant on our consumers to fuel their economic growth. They ship product and receive dollars. Then they repatriate those dollars in US Treasuries. They can buy other things, but the risk/reward because of currency fluctuation is too high. They have to be bidders on US debt.

This makes the borrowing costs for the US Treasury artificially low. Borrowing costs would increase significantly if China didn’t have to buy as much debt. Since we are playing a speculative game, suppose China cut it’s purchases by half-the same as the currency value. Where would short term rates be? Can you say 3%? That would play out further down the curve. With the amount of debt Obama has issued, it’s not clear where 10 year notes would be but it would not surprise me to see them at 8% or higher.

Higher US Treasury rates increase the borrowing rates for business and slow growth. There is a finite supply of money at any point and time in the economic system. More government borrowing crowds out businesses.

Higher inflation and higher rates would crush the stock market. Stock markets never like those two items. In the pits, we’d call it a puke. The financial crisis might be mild in comparison.

It gets much worse.

The US is uncompetitive in the labor market. Much of this is because we have a much higher standard of living. To get workers to work, you have to pay a higher rate. However, a lot of it can be explained by union rules in many of our labor markets. The higher value of Chinese currency will make our goods cheaper to China. What do we make that they want that they don’t already buy? Additionally, the factories that Schumer has his eyes on, like GM, have so much slack that they would have to hire relatively few workers to keep up with demand.

In reality, the high inflation, high interest rate environment that Financial engineer Schumer seeks would increase unemployment.

No doubt, there is tension in US-China relations. But, instead of browbeating on them publicly on their currency, we ought to be negotiating to try and get them to open their markets to us. We ought to be teaching them how to set up a system of law with property rights so that companies can feel secure in competing there. We also might want to educate them in the economic reality that they will face someday-until they increase their indigenous consumption they are totally reliant on the US consumer for their growth. No country has sustained itself without growth of both kinds; free trade with others and consumption by its own citizens. Raghu Rajan expertly laid out the landscape in his book Fault Lines.

No Senator Schumer, don’t be an economic dunce. You and your compatriots have gotten us into enough trouble over the years.

The information in this blog post represents my own opinions and does not contain a recommendation for any particular security or investment. I or my affiliates may hold positions or other interests in securities mentioned in the Blog, please see my Disclaimer page for my full disclaimer.

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