"China is manipulating its currency," proclaimed incoming US Treasury Secretary
Tim Geithner. Talking about "manipulation" is helpful only if one's intent is
to impress a local and insult a foreign audience. More productive may be plain
talk - the US and China could issue a joint statement along the lines of:
"China and the US agree that both will act in their respective self-interest in
setting exchange rate policy."
Many factors including supply and demand for a currency ultimately determine
exchange rates. The US is doing its share to try to manipulate the dollar,
albeit with mixed results. Among other acts, last summer, the Treasury decided
to make the guarantee for the housing agencies Fannie and Freddie more
explicit. With the Chinese and other foreigners being the main
buyers of US debt in recent years, there was a threat that these buyers would
abstain.
Foreign investment in the US had fallen off a cliff in the second quarter of
2008; the absence of foreign buying could have caused a panic in the dollar. By
providing the guarantees, the US seemed the least risky country for short-term
money, giving a boost to the dollar. Note, however, that the inflows were
mostly parked in short-term Treasuries, not exactly an endorsement of the US
economy, but more likely a panic trade that may be unwound again.
While last summer's action was aimed at avoiding a disorderly collapse of the
dollar, policymakers have made it abundantly clear that they want a weaker
dollar. The ritual that Geithner followed to state that a strong dollar is in
the interest of the US has become a farce. Suggesting China should allow its
currency to appreciate is certainly not compatible with it.
Neither are Federal Reserve chairman Ben Bernanke's repeated references that
weakening the currency by going off the gold standard helped the US out of the
Great Depression by "allowing prices to float to the pre-1929 levels". In our
assessment, the Fed is encouraging inflation, so that the relative prices of
homes to all other goods and services will come down.
That may be the Fed's "plan B" as it doesn't want absolute home prices to come
down any further; a weaker dollar contributes to achieving this. We have
cautioned in the past that a country cannot depreciate itself into prosperity,
but that won't stop policymakers from trying. Pulling interest rates to near
zero is also a form of currency manipulation, trying to make the currency less
attractive.
While former Fed chairman Alan Greenspan always avoided discussing the dollar,
the current Fed chairman embraces the confrontation, not just by seeking the
discussion, but also through action. Beyond lowering interest rates, the Fed is
trying to weaken the dollar with its purchases of agency securities and
government bonds.
With their government guarantees, Fannie and Freddie are buying billions of
dollars worth of mortgage securities to lower the cost of borrowing to
consumers; the agencies have also lowered their traditionally high standards on
who qualifies for subsidized loans. Already Freddie Mac has asked Uncle Sam for
another $35 billion as it is throwing taxpayer money at consumers. The
activities pursued are in the realm of currency manipulation, as the types of
securities foreigners would typically want to buy are inflated in price,
discouraging the purchases.
Indeed, in any market where the Federal Reserve has engaged in purchases -
agency securities, mortgage-backed securities, providing funding for consumer
loans, the commercial paper market, to name a few - the Fed is replacing
rational buyers rather than jumpstarting the private sector. Why would a
rational person buy securities that are artificially inflated in price? If the
Chinese dare to buy these securities anyway, then they must be as guilty as the
US of currency manipulation.
Indeed, that's what it comes down to: the US wants to have a weaker dollar and
China wants to be in control of when to allow the yuan to appreciate. Insulting
China is not the right way to go about it. China has to recognize that a
stronger yuan is in its national interest. While the US is accelerating its
market interventions with implications for the dollar, China is working hard to
allow for more exchange-rate flexibility.
In our view, China cannot grow itself out of the current global economic
downturn with a cheap currency. US consumer spending simply may not pick up
fast enough because US policies are aimed at propping up the broken system in
place with high levels of consumer debt rather than fostering sustainable
growth that includes savings and investments.
Paradoxically, while the Chinese yuan may be cheap, overall policies continue
to be relatively tight. China is aware that it has its own inflated property
prices and is willing to allow price declines and failures of real-estate
developers.
China has also not exhausted its potential to provide a stimulus to the
economy: infrastructure projects in the pipeline in years to come could be
moved forward far more aggressively.
We would favor a major campaign to encourage domestic entrepreneurialism to
jump-start a more balanced economy not as focused on exports. Part of the
reason for the reluctance on China's part is because of inflationary fears.
While everyone talks about deflation right now, inflationary pressures as the
world recovers and as a result of the spending programs could be contained if
China allowed the yuan to appreciate.
When China recognizes that it is in its interest to have a stronger yuan, China
will act. In the meantime, the US and China are playing a game of chicken.
However, it is unclear what winning means in this context. The US seems somehow
excited to weaken its currency, depriving hundreds of millions of the
purchasing power of their savings.
Conversely, China's reluctance leads to more problems than it solves for China.
China won't be bullied by the US. However, a little more diplomacy and a little
less populism may be beneficial to both China and the global economy.
Axel Merk is manager of the Merk Hard and Asian Currency Funds,
www.merkfund.com. Merk Insights provide the Merk perspective on
currencies, global imbalances, the trade deficit, the socio-economic impact of
the US administration's policies and more.
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