The Hindu Business Line : The yuan-dollar charade

A yuan revaluation will make goods more expensive for Americans, reducing consumption, apart from forcing the US to hike interest rates on dollars held by Asian central banks. Both the above will push the US into a recession. Why would the Treasury Secretary push for a policy with such an outcome, asks SHANMUGANATHAN N, offering some answers.

The Bush administration is under pressure from US lawmakers threatening to push ahead with legislation imposing punitive tariffs on Beijing if the latter refuses to allow an appreciation of the yuan. They accuse China of keeping its currency grossly undervalued to make its exports to the United States cheaper — a key factor cited for the snowballing US trade deficit with the Asian giant that hit $232 billion last year.

The US Treasury Secretary, Mr Henry Paulson, said after last month's "Strategic Economic Dialogue" in Washington that the 15-minister strong Chinese delegation to the talks "clearly see the need and stated the principle of greater renminbi flexibility."

Paulson further remarked that "... the pace of change has picked up, but I believe it will be very much in their best interest and the rest of the world's best interest if they will move more quickly".

Before elaborating on the farcical nature of such dialogues, let me explain what will happen to the currency situation — the yuan will appreciate against the dollar, perhaps by as much as 50 per cent or more over the next few years, and yet this will do very little to alter the trade deficit between the US and China. All that a revaluation will achieve is to transfer purchasing power from the borrow-and-spend Americans to the save-and-produce Chinese.

To that extent, Mr Paulson is probably right when he states that it is in the best interest of the rest of the world to allow the dollar to depreciate. However, the above-mentioned currency appreciations will happen irrespective of Mr Paulson's adventures and/or deliberate decision-making on the part of Asian central banks.

Before explaining the rationale for the above, let us for a minute think of what will happen when the yuan is allowed to appreciate against the dollar. It will still be extremely difficult for American manufacturers to compete against the Chinese, who probably take less than 10 per cent of the average American wages, work 16 hours a day, six or perhaps seven days a week, without onerous labour laws and health insurance constraints. It will take more than a currency revaluation to fill the ships that are returning empty from US seaports after unloading all the Chinese-made goods.

Parallel with Euro

If you are not convinced, just look at what happened with euro appreciation and US trade deficits with the Euro zone in the last five years. Although the euro has appreciated nearly 40 per cent against the dollar, the trade deficit of the US the Euro Zone has nearly doubled — from $64 billion in 2001 to almost $120 billion in 2006. This is in spite of the fact that the Euro zone has a cost structure and labour laws very comparable to the US. So, if currency appreciation did not alter the trade deficits with the Euro zone, it most certainly will not achieve the same against China.

What a revaluation of the yuan will do in the short to medium term (3-5 years) is to make goods more expensive for the Americans, possibly reducing "real" American consumption. Additionally, to compensate for the dollar devaluation, the US will be forced to hike interest rates on the dollars held by the Asian central banks. Both the above — reduced consumption and higher interest rates — will push the US into a recession. So why would Mr Paulson actually push for a policy that would cause a US recession? Clearly, the official posturing of the "Strategic Economic Dialogue" is just a mask.

Behind the Scenes

First, the thought that a borrower (the US) can dictate terms to a lender (China) is just plainly absurd. The US relies on China to finance its trade deficit and to reinvest the dollars purchased in low-yielding government treasuries. So the US is not only dependent on the Chinese for the products, but also on the Chinese Government for financing the purchase. While China pulling the plug on the dollar would mean it would lose out on the $2 trillion worth of reserves the Chinese central bank holds, this could be more than offset by appreciation of the Chinese currency, of which it holds a whole lot more.

What Mr Paulson must be secretly hoping is that the Chinese continue to maintain the narrow band that allows the sham of the American consumer being the strength of its economy to continue for a few more years (perhaps at least till the 2009 presidential elections). To believe that a near trillion-dollar trade deficit can be altered without fundamental structural adjustments to the economy is, clearly, wishful thinking. The changes would have to begin with a recession-induced under-consumption, savings and restarting the lost manufacturing infrastructure.

Financing US consumption

The sooner the Asian central banks stop financing the irrational consumption patterns of the US consumer, the better it would be for the rest of the world. And, ironically, this would be a good thing even for the long-term health of the US, as the longer the postponement of the required structural adjustments in the US, the more painful would be the subsequent rebuilding effort.

The reality of trade deficits will, sooner or later, force the adjustment of exchange rates of the dollar with the other trading partners. Many analysts point out that trade deficits have existed since the 1980s and so there is nothing new today to warrant a negative view on the dollar exchange rates. What, however, has changed is the tolerable limits of US-exported inflation in the other economies — that is, due to the benign commodities cycle from 1982-2002, most central banks were happy to prop up the dollar without it impacting the consumer price inflation in their economies.

That no longer is valid and most countries now look at currency appreciation as a way of managing inflation. Some countries, such as Kuwait, have gone ahead and completely abandoned the dollar peg and it's only a question of time before China does so too. And when that happens, the purchasing power will get transferred to the Chinese and the manufacturers will then become the deserving consumers as well.

(The author is a Director at Benchmark Advisory Services and can be contacted at shan.sundaram @benchmarkconsulting.in . His previous articles can be accessed at http://financial-musings.blogpsot.com)