Thomas Palley

The United States Congress is currently contemplating critical legislation aimed at remedying the huge U.S.-China trade deficit. China and businesses that benefit from Chinese imports oppose this legislation, and to discourage action China has hinted at retaliation – including possibly selling its U.S. Treasury bond holdings. That threat has prompted some to argue against legislative action on grounds that risks of a trade war are too large and costly. Such thinking is mistaken. The reality is China’s threats are empty, whereas its currency manipulation is wreaking significant real damage on the U.S. economy.

The Ryan – Hunter bill (H.R. 1498), now before the Congress, proposes treating currency manipulation as a form of illegal subsidy that would be subject to countervailing duties. In this fashion Ryan – Hunter aims to offset China’s under-valued currency and circumvent China’s refusal to meaningfully revalue its exchange rate.

There is widespread agreement that China’s currency is under-valued and harming the U.S. economy. This harm works through the trade deficit and imports that displace spending on domestically produced goods, thereby injuring manufacturers. Additionally, the under-valued currency displaces investment by encouraging business to invest in China rather than the United States. The challenge for the U.S. is how to respond in light of China’s exchange rate intransigence.

Through its persistent trade surpluses China has accumulated over 400 billion dollars of Treasury securities and it is now the second largest foreign holder (after Japan) of government bonds. The fear is that China may retaliate against the U.S. by selling bonds, causing the price of treasuries to fall and interest rates to rise. That in turn could trigger financial disruption, which in conjunction with higher rates could topple the economy into recession.

Such reasoning is deeply flawed for several reasons. First, China has little incentive to engage in such tactics. If it starts selling bonds that will drive prices down, causing large capital losses on its holdings. More importantly, China has no interest in playing Russian roulette with the U.S. economy as that threatens its own economy. The reason China refuses to revalue its exchange rate is because it wants to retain a competitive advantage enabling it to sell in U.S. markets. Causing a U.S. recession would destroy the very market in which it wants to sell. Worse than that, a U.S. recession could trigger a global recession, thereby undermining markets in Europe and elsewhere that China also relies on.

Second, the Federal Reserve can always intervene to mitigate the effect of any Chinese selling. Thus, were China to irrationally start selling, the Fed could step in and buy those bonds in so-called “sterilizing operations”. China would then be left holding lower-yielding bank deposits supplied by the Fed, and the Fed would hold the bonds sold by China. This would prevent interest rates from spiking and U.S. taxpayers would actually benefit by saving the interest that would have been paid to China.

Thereafter, China could decide to sell its bank deposits and buy foreign currency. If it were to try and buy renminbi and repatriate its dollar holdings that would quickly cause China’s exchange rate to rise, which is exactly what U.S. policymakers desire. Alternatively, China could buy yen and euro, which would cause the dollar to depreciate against these currencies. That too would benefit the U.S., especially if the yen were to appreciate, as this would make U.S. producers more competitive versus European and Japanese companies.

Appreciation of the euro and the yen would then shift America’s exchange rate dispute with China to Europe and Japan. This would expose China to risk of retaliatory action from these countries, which are much more administratively aggressive in protecting their markets than is the U.S. As a result, China could find itself at loggerheads with all its major customers (the U.S., Japan, and the European Union), suggesting it will not go this route.

Meanwhile, passage of Ryan – Hunter would enable U.S. manufacturers to seek countervailing duties offsetting the subsidy implicit in China’s currency manipulation. That would raise Chinese product prices in the U.S. and reduce Chinese imports, yet the benefit of higher prices would go to the U.S. government rather than Chinese manufacturers. That again makes no sense for China, suggesting that Chinese policymakers would prefer exchange rate revaluation to tariffs. That way China at least gets the benefit of higher prices.

In sum, the U.S. and China are currently engaged in a policy struggle that resembles the game of “chicken”. Policy analysis can help disentangle the likely outcome of such a game by examining the credibility of each country’s postures. Such analysis shows China’s threats are empty. China relies on export-led growth to provide demand for its products and attract foreign direct investment. That means it cannot afford to destabilize the U.S. economy or the global economy. And if it irrationally tries to do so, the Federal Reserve has the means to neutralize its actions.

Copyright Thomas I. Palley

This entry was posted on Tuesday, September 4th, 2007 at 6:46 am and is filed under China, U.S. Policy. You can follow any responses to this entry through the RSS 2.0 feed. Responses are currently closed, but you can trackback from your own site.