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By Paul Quintaro

On Monday, the U.S. senate voted to begin the debate on a bill that would place trade restrictions on countries deemed to be undervaluing their currencies.

The Chinese would be the key target of the bill, as China has been widely characterized as a currency manipulator by many economic commentators.

On Tuesday, the Chinese government responded, noting that the passage of the bill would signal the start of a trade war between the two countries.

Currently, China maintains a peg of its yuan to the U.S. dollar. Under the peg regime, China alters its money supply so as to ensure a fixed rate of exchange with the U.S. dollar.

This pegged regime prevents the yuan from appreciating against the U.S. dollar, ensuring that China’s manufactured goods remain at a relatively flat point in terms of pricing.

If China’s yuan was allowed to appreciate, China’s manufactured goods would become relatively more expensive to foreign consumers (such as Americans) and therefore less attractive. American consumers may then substitute the Chinese made goods for goods manufactured in other countries—perhaps even including goods produced in the U.S. itself.

Why would congress undertake such a bill?

If the Chinese revalue their currency upwards, and the relative price of their goods becomes more expensive, demand for American products may create demand for American jobs—manufacturing jobs that might help the nation’s unemployment problem.

With an upcoming election and an unemployment rate that remains persistently above 9%, increasing the demand for American manufacturing jobs might be an attractive option for a government that seems stymied in its efforts to drive job creation.

Is the bill necessary?

In recent years the Federal Reserve has increased liquidity in the financial system through its policies of quantitative easing (QE). Many critics of the Fed stated that these operations would lead to significant inflation in the U.S. economy.

With the exception of a seemingly short-lived commodity boom, that inflation has thus far failed to materialize.

Instead, emerging market countries like China may have been sopping up that excess liquidity, as inflation in these countries has accelerated at a tremendous rate.

Famed investor Bill Ackman recently revealed that he believed that the Hong Kong dollar was set to appreciate. Arguing that inflation in Hong Kong would force a revaluation, Ackman presented a bullish investment thesis to CNBC’s Delivering Alpha conference.

Assuming Ackman’s idea was accurate, would China be forced to do much the same? Would China eventually have to appreciate its currency anyway?

Ultimately, the bill may fail to pass. Should it become law, it will be interesting to see if the Chinese cave and revalue the yuan, or make good on their promise and instigate a trade war.

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Source: U.S. Senate To Force Trade War With China?