from Follow the Money

Surprise, Surprise: the Treasury waited til December to clear China of currency manipulation

December 6, 2004

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Blog posts represent the views of CFR fellows and staff and not those of CFR, which takes no institutional positions.

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It looks like John Snow did Andy Card one last favor before stepping aside: late on Friday, the Treasury quietly issued the annual foreign currency report. To no one’s surprise, the report declared that China was not manipulating its currency. China is now legally in the clear for another year.

I cannot really criticize the Treasury for coming to this conclusion: the legal consequences of declaring that China is manipulating its currency are dire -- the trade equivalent of nuclear war. Wal-Mart would never stand for it! Seriously, there is a structural problem with the legislation: the sanctions for the crime of currency manipulation are so severe that they make prosecution for the crime very difficult.

And in a strange way, the Europeans have a better case for finding China guilty of currency manipulation that the U.S. does. A pegged exchange rate per se is no crime, but pegging to the slumping US dollar (the American peso, per the Economist) might well be.

I do hope that the incoming Treasury Secretary has a plan for convincing China to revalue -- and matches that with a plan for reducing the United States’ borrowing needs over time. You need both, not just one of the two. An easy place to start: decouple "liberalizing" China’s exchange rate regime (letting the market set the exchange rate) from revaluing the renminbi. In the short-run, a simple revaluation is all that is needed, and it requires a lot less "technical" work than moving toward a dirty float or a basket peg with a band.

Right now, the health of the world economy hinges on the continuation of two bubbles: a consumption bubble in the US and an investment bubble in China. Steven Roach is feeling a bit less bearish today, which means he thinks that the odds both bubbles will last another year have gone up.

It is pretty clear what would happen to China if the US consumption bubble popped before China’s investment bubble. Manufactures account for something like 50% of China’s GDP, and exports to the US account for between 1/4 and 1/3 of China’s manufactures output (exports to the US will be about 14% of China’s 2004 GDP). A slump in US consumption would translate into a slump in Chinese exports and China’s output -- and that, in turn would trigger a sharp fall in global commodities prices. The 1998 Asia crisis would play itself out in reverse ... the only real question is whether China would be able to play the role the US played in 1998-99 -- as the world’s consumer of last resort. Chine would do the world a great service if it took steps to let its imports rise even as its exports started to fall (relatively speaking) during a US consumer slump. Yes, that means accepting a significant trade deficit: See what happened to the US between 1998 and 2000 when Asia slumped. Call it the price of global economic leadership.

Now think what might happen if China’s investment bubble burst before the US consumption bubble. A bursting of the investment bubble would lead China’s current account surplus -- now around 3% of GDP -- to widen. A bursting of China’s investment bubble would also send commodity prices lower, reducing China’s import bill and increasing its trade and current account surpluses. And, as Lardy and Goldstein argue, historically a slump in investment has been associated with a slump in consumption (higher savings), which also would tend to lead to a larger current account surplus. All this is a fancy way of saying that it is most strange for a country in the midst of an investment boom to still run a current account surplus. Get rid of the investment boom, get rid of the commodity price shock and China’s current account surplus would skyrocket. New steel plants would start producing for export.

That would make it harder for the Treasury to clear China of currency manipulation (yes, the two strands of this post do link together). A higher current account surplus would also make it easier for China to keep on financing the US. Or would it? Remember that China’s ability to build up its reserves by $150 billion plus per year currently hinges on its ability to attract $100 billion or more in net capital inflows on top of its $50 billion current account surplus. The end of the investment boom would increase China’s current account surplus, but it also might lead to a fall in capital inflows to China ... the net effect is more ambiguous. But if the rise in the current account offset any fall in capital inflows, a slump in Chinese investment could free up more Chinese savings to finance the US consumption boom ... I would not want to count on it though. God help us all if both the Chinese investment bubble and the American consumption bubble burst at the same time.

Finally, two small technical critiques of the Treasury report -- though it is fair to assume the Treasury opted to highlight the facts that best support its argument that China is not manipulating its exchange rate, and thus is not unaware of these points.

1) Yes, China’s real exchange rate appreciated by 3% bit in the first part of the year, and inflation differentials with the US and the world had something to do with that. But China is tied to the dollar, and the dollar also appreciated 3% v. other major currencies in the first half of the year. Interesting correlation. Suffice to say that the dollar is no longer going up v. other major currencies, and the recent slump in the dollar-renminbi has largely offset inflation differentials with the rest of the world ...

2) Looking at the raw (not seasonally adjusted) trade numbers for a country like China over the first six months of the year alone can be a bit misleading. There is strong seasonality in China’s export: US retailers traditionally import lots more in the late summer and fall to build up inventory ahead of the holidays. So China’s full year trade surplus may well be different than two times its trade surplus (or deficit) in the first six months of the year. After six month’s China’s 2004 trade surplus with the US was $69 billion, after nine months it was $114 billion, and a simple extrapolation leads to a $155-160 billion estimated bilateral deficit for the year (not 2*$70 billion, or $140 billion). That would be an increase of more than $30 billion from the $124 billion bilateral surplus last year.

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