Should China Continue Propping Up the U.S. Dollar?

By Kindred Winecoff

Teutonic Knight, a commenter at Seeking Alpha (where some IPE at UNC posts are syndicated) asks a very good question apropos of this post:

What is the real motivation or perceived benefits to the U.S. of asking to Chinese to re-evaluate the Yuan upward? If say the Yuan is up another 15% (not a high magnitude in my view to begin with) then the "cheap" Chinese household goods may just rise 10 to 15% in price.

China and the United States have had a trade imbalance for quite a long time. In theory, when one country (the U.S.) imports more goods from a country (China) than it exports to it, the value of the currency of the importing country (the dollar) sinks relative to the value of the currency of the exporting country (the yuan). At least, this is supposed to happen when the value of currencies is allowed to float.

If the value of the dollar sinks relative to the yuan, then imports from China to the U.S. become more expensive, while exports from the U.S. to China become less expensive. Therefore, exports from the U.S. should rise while imports from China should fall. The price mechanism prevents countries from running persistent trade deficits that can have adverse long-run effects on employment.

In the real world version of this example, China has subsidized its exports to make them cheaper, and has then used the proceeds from the trade imbalance to buy U.S. Treasuries and other dollar-denominated assets, thus propping up the dollar and making Chinese imports even more attractive to U.S. consumers.

For a long time, the U.S. was more than happy to oblige, because this made it possible for us to extend cheap credit to businesses and consumers without generating a lot of inflation. The U.S. was running at or near full employment, so there seemed to be little short-run downside. China was content with this state of affairs because it allowed them to employ millions of its impoverished citizens in labor-intensive exporting industries, thus raising standards of living for the most people in the shortest amount of time.

However, everyone knew that in the long run this trade imbalance was unsustainable. This is why people like Nouriel Roubini have been predicting a currency crisis in the U.S. for several years now: eventually the dollar was going to have to fall. According to Roubini and others, the bigger the trade imbalance became, and the larger the U.S. national debt grew, the more painful the inevitable transition was going to be.

A gradual adjustment is always preferable to a sudden shock, so the U.S. has been cajoling the Chinese to let the yuan rise against the dollar in stages. The Chinese have done this, but the U.S. has been concerned that the process is going too slowly. The Chinese have been reticent to move too quickly and forego the employment gains in their exporting sector.

Now that the U.S. is well below full employment, the matter has become more urgent: we need the dollar to decline some in order to boost our exporting industries and spur employment. Despite interest rates close to zero, the dollar has actually gained value against many of the world's currencies since last Fall. Unfortunately, China is facing a slowdown as well, and they want to keep their employment levels from slipping, so they want to keep the yuan from rising much more in the short run.

And that's basically the state of things right now. It appears that we may be at an impasse. Structural adjustment is needed, but the U.S. is hesitant to force that adjustment through tariffs or capital controls, and China is hesitant to let the yuan fall much further.

Of course, this simplistic explanation ignores all other countries besides China and the U.S., and all other currencies besides the yuan and dollar. The full story is much more complicated, as Russia moves to devalue the rouble, France gets concerned about the shocking weakness of the British pound, and the Japanese yen rises against all major currencies, leading to rising unemployment in the Land of the Rising Sun. In a global recession, nearly all countries are incentivized to devalue their currencies in order to boost employment and stave off deflation. But such competitive devaluation can have devastating consequences for the global economy.

Comments

[Tradememe:]

At this point in time considering the kind of economic situation in the US, it is better that China continues to prop up the USD. But when things stabilize in the future, it is preferable that there is a decoupling between the Yuan and the USD.

The appreciation of the Yuan will improve the lot of the Chinese people in general and not just those who live in the urban areas or the exporting areas of China. And this will create the internal consumer market that will save their exporting industries from the global recession.

2009 Jan 27 07:08 AM

[kelm:]

Much of the discussion about China's currency at this point is political, not economic. If China greatly devalued the Yuan s the US consumer suddenly going to go on a new buying binge? No. Asian exports have plunged by 35% from all of those countries including China. The demand is not there. I am afraid we are setting up to use China as an excuse for protectionist measures which will play well with unions (if anyone is left working for them) but is contrary to the lesson's that supposedly were learned during the great depression.

2009 Jan 27 09:40 AM

[seneca:]

What few people recognize (but we investment bankers do) is that any appreciation in the RMB will mean that the purchasing power will rise as well. Forthe very excellent executives of US businesses building up such wonderful world-class companies [ironic], this provides an easy out because the Chinese can in theory pay even higher prices and certainly outbid anyone when it comes to acquisitons. Then the f---- stupid politicians like Schumer and Graham will then have to deal with blocking the Chinese from 'buying up our country'. We certainly don't want to sell the country out to the yellow people [ironic].

2009 Jan 27 03:22 PM

[ariosto:]

Floating fiat currencies will always lead to structural problems
vis-a-vis each other. We need currencies backed by something
tangible!!!

2009 Jan 27 04:39 PM

[Lonestar1:]

This has been discussed in many other boards. But nobody can name ONE concret benefits to US if China's yuan appreciate. Substantial changes in currency values is a decisive destabilizing force in globalization. China began the revaluation in July 2005, coinciding with timing of US housing's entering of bubble zone. Hot money left US and entered China in order to capture the benefits of revaluations. This continued all all the way to mid 2007 when the bubble began to bust.

2009 Jan 27 04:57 PM