Chinese backlash on US currency stance could be detrimental

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McCain and Obama

Photo Credit: Time, Inc.

Though China has been relatively untouched as it pertains to politics, the hefty Chinese trade surplus with the United States is slowly being challenged by more and more politicians. Recently, both Obama and McCain have touched on Chinese currency issues and the large trade surplus with two different points of view.

Obama would like to see more economic sanctions, such as higher import taxes on Chinese goods, to force the country to free float their yuan. He has defined the Chinese currency situation as an export subsidy, and he would like to put higher duties on imported goods from China.

John McCain has taken another approach, arguing that he would not support tariffs or other taxes on Chinese goods simply due to the large trade deficit. Instead, he favors free trade, but made a point to say that he would act ‘quickly and effectively” on unfair trade practices, practically leaving the door open for sanctions if the currency situation is deemed unfair.

A long talk with little change

The topic of Chinese currency manipulation has been surfacing and resurfacing before China lifted its dollar peg in favor of a float against a “basket of currencies” as approved by the Chinese government. Some have insisted that this is not much better than the peg, as China can pick currencies that are most beneficial to them; others argue that the basket has performed well, pushing up China’s currency more than 20% since the peg was lifted. The Chinese government’s holdings are nearing $2 trillion of foreign currencies as a result of the trade imbalance, and some argue that the “basket of currencies” may just be a collection from what China already owns. If that is the case, that China’s basket is truly based upon what currencies it is holding, then the performance of the yuan is understandable because the currency is accurately backed by foreign holdings of other currencies.

To say that the presidential candidates will have a major role in the development of trade between the United States and China is a complete understatement. Even three years after the lift of the peg, talks about pressuring China into economic sanctions is still finding its time in Congress and in the media. Henry Paulson, as treasury secretary, has stated that the value of the Chinese currency does not “reflect reality” and that there is greater need for economic reform than when the first pressures to revalue started in July 2005.

Revaluing currency favors US Trade

Revaluing the Chinese Yuan would be indefinitely more favorable to the United States than it would to China, which thrives on the economic benefits of a cheaper currency that allows itself to sell more products to developed countries with higher minimum wages and currency values. Many economists expect that the Chinese yuan could appreciate another 20% if the currency was left to freely float as opposed to a trading range set by the basket of currencies.

For US consumers, this would mean that Chinese goods would be another 20% more expensive, and thus, spenders would be driven to buy US goods rather than imports. Though this all sounds great in the idealistic sense, selling this idea to China will be tough. Threats of imposing tariffs or economic sanctions certainly gives the Chinese government a poor sense of security. The threat that China would strike back could be even more detrimental to trade relations – ones that have been less than forgiving for the past few years.

Image Source: MSNBC

Economic backlash of imposing sanctions

It is likely that with a freely floating currency, China would strike back by selling off US assets. Rather than let the value of their foreign holdings depreciate, China would make an economic and retaliatory action of selling US assets until the yuan is fairly valued. Selling its US dollar denominated holdings would mean that the more than $1 trillion China currently holds would wash the markets in dollars. US inflation would soar, as the dollar would fall likely by a figure greater than 10% in just a matter of weeks or months, or however long the sell off would occur. As of now, it is not in the best interest of the Chinese government to sell US dollars, as it would have a negative affect on Chinese exports resulting from a cheaper dollar, but in terms of retaliation, there would be no better way to strike back at US economists and politicians.

The economic power that China holds is its biggest strength. Outside the realm of military power, China does have the ability to throw a quick blow to the US economy in the form of a quick sell off of dollar denominated assets. Today alone, the largest US money supply total rests at about $11 trillion, while China’s holdings alone of US dollars number about $1.4 trillion dollars, according to a study conducted in September 2007. This gives China more than 10% of total US currency circulating around the world.

Chinese reserves hurt American dollar

Photo Credit: ChinaBlogspot.com

US Dollar would drop on Chinese selloff

If China were to dump $1.4trillion in assets, it would be impossible for other firms or governments to make up that amount of money in the short time of the sale. Instead, what has previously worked as a deflationary effect on the value of the US dollar would quickly become inflationary. There is not enough liquidity or investor interest to take on $1.4 trillion in US currency. Simply, the bids for the currency would be so low that the US dollar would absolutely tank. Though China controls 12.7% of the US currency, chances are that the drop would be leveraged to the point of a drop greater than 12.7%, and potentially double that figure.

That means 25% more expensive gasoline, more expensive food, and a dollar that has barely any purchasing power anywhere around the world. For the United States, economic sanctions against China should be kept out of reach, and instead of waking the sleeping giant, politicians should push corporations to compete in the United States rather than outsource to various parts of the world.

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