China-U.S. relations have dominated this week's headlines with Hu Jintao's official state visit to America. And there is much to talk about with respect to what is arguably the world's most important bilateral relationship.
'Bleeding-hearts' types will no doubt want to focus on human rights issues, such as the ongoing imprisonment of China's recent Nobel Peace Prize winner, Liu Xiaobo, to the China's not so secret effort to wipeout Tibetan civilization.
And those concerned with the military balance of power can point to concerns about Chinese espionage, secret development of sophisticated weaponry like a Chinese stealth fighter, and China's navy contesting free navigation in the South Sea.
The Renminbi Runaround
There is also the matter of U.S.-China economic relations. As far as the U.S. is concerned, the big one is the exchange rate of China's currency, the renminbi (yuan). It is widely agreed that China's currency is undervalued by as much as 20-40%, providing China with an unfair trade advantage. Much has been written about this issue previously here.
Former Secretary of State and and National Security Advisor, Henry Kissinger, appeared on Charlie Rose this week to discuss relations with China. Not surprisingly, Kissinger argued for a diplomatic solution to the renminbi. While acknowledging that he is not economist, Kissinger believes there should be some way to bring the Chinese around on revaluing the renminbi by offering something in return. My question is hasn't the U.S. already tried that ad nauseam?
Throughout modern history the world's trade and currency order has always followed a set of explicit and implicit 'rules of the game', so to speak. Over the last two decades China has benefitted significantly from first having access to the world's markets and later gaining entrance into the World Trade Organization. While WTO rules do not cover exchange rate manipulation, one of the hallmarks of our current semi-free trade system is floating exchange rates. China exercises heavy control over its exchange rates in a manner completely unlike other major trading powers, such as the U.S.
The key question, put simply, can be expressed as follows: why is there one set of currency rules for China, and another set for everyone else?
The Nuclear Option: Is a U.S. Default 'On the Negotiating Table'?
We can argue how freely the U.S. dollar is allowed to float given recent Fed money printing programs like QE2. However, as Bernanke implied during a speech in Frankfurt part of the justification for QE2 is China's currency policy.
Approximately 50 million Americans are out-of-work and considered uncompetitive, or 'priced out', in today's globalized labor marketplace. Hu Jintao would have everyone believe that the U.S.'s competitiveness problem is due to cheap Chinese labor, not the yuan's exchange rate. But it doesn't take a mathematician to realize that making Chinese goods 20%-40% more expensive by revaluing the renminbi upwards could make a material difference in export competitiveness.
China has continued piling up massive exchange reserves holdings with $3 trillion in largely U.S. dollar denominated assets and counting. How much is enough before China is willing to budge on the yuan's value? And if the Chinese won't move what should be the U.S.'s policy response, and perhaps as importantly by when should the U.S. take action?
At a London School of Economics event this week chaired by Professor Niall Ferguson, economist and author Dambisa Moyo argued that the U.S. should consider defaulting on its debt. In fact, many view the Fed's previously mentioned QE2 program as the opening salvo in an implicit default.
While this move would perhaps deliver just deserts to the world's largest currency manipulator, the bluntness of Moyo's recommendation would be devastating for not just China but for every other country which holds U.S. dollar reserves, not to mention the U.S.'s global standing. In other words, a meaningful default is not a realistic option, and the Chinese know this.
Instead, if the Chinese remain intractable on the value of the renminbi then some form of trade sanctions, along the lines of the legislation currently under discussion in Congress, is the appropriate next step. And I for one would argue the time for such action is now.
From an investment perspective, any slowdown in the Chinese economy due to trade sanctions will weigh heavily on commodities in particular. Whether the U.S. dollar would also come under pressure, with China retaliating by reducing U.S. dollar denominated holdings, is an open question. The Obama administration would like to see a weaker U.S. dollar, and the Chinese know this.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
