ECB Governing Council and the Financial Stability Board warned on October 28, 2010, that worldwide trade imbalances and currency interventions were threatening the process of global recovery. The US legislators have recently approved a Bill, which, if passed, will enable the US to levy tariffs on imported goods. But it raises a spectre that is haunting the other central banks?the ghost of the 1930s, when protectionism started by the US led to a collapse in trade, a big contributor to the Great Depression.
Over the past decade, the world has been divided into ?deficit? countries and ?surplus? countries. Deficit countries, like the US and UK, borrow from the rest of the world, so they can import more than they export. Surplus countries, like China, Japan and by some measures, India, do the opposite.
During the financial crisis and global recession, imports by the deficit countries?and exports from the surplus countries?briefly collapsed. But with the recovery, the latest trade data suggests that the old imbalances have begun to reassert themselves, leading to tensions. The US says it wants to export more to help its economy recover. But the surplus countries don?t want their exporters to lose their competitive advantage.
The quickest way to gain a competitive advantage is through a weaker currency. And with the global recovery so weak, nearly all countries have been complaining that their currencies are too strong. During the 2008 financial crisis, most currencies fell against the dollar. Investors bought the dollar because they saw it as a safe haven. But since then, most currencies have slowly risen against the dollar.
China continues to follow a policy that pegs the yuan closely to the dollar. It does this by maintaining complete control over the exchange rate; it pays for dollars earned through the sale of exports, and exporters are required to convert all foreign currencies to the yuan. This is also how China has amassed a considerable foreign currency reserve of $2.5 trillion. This is an important consideration, as the US accounts for nearly 20% of China?s global sales. In 2009, China?s exports to the US were about $300 billion and if the yuan were allowed to appreciate significantly against the dollar, China would lose much of its competitive edge. The Chinese are worried that if they strengthen their currency too quickly, it could hurt their export companies and destabilise their economy.
China?s artificial exchange rate presents a daunting challenge for American companies. The US President obliquely referred to the trade deficit with China in his State of the Union address when he suggested that reducing the deficit by half would result in new jobs for Americans.
Without a weaker dollar, the US would have no hope of meeting its goal to double exports in five years. Dollar depreciation will also generate inflation and ease the debt burden that the financial crisis dumped on the US government. If the global financial crisis was about the US nationalising private debt, then in the post-crisis period, for the economy to recover, it is evident that the US wants to internationalise its national debt. If that happens, the biggest loser would be China because it currently has the largest holding of US Treasuries.
Weakening the dollar and high inflation would mean the US ends up paying back less than what it borrowed, apart from lessening the trade gap. This would help in meeting its target of reducing the trade gap by 50% over a four-year horizon. Even if the dollar weakens against other currencies, so long as the yuan is pegged to the dollar, it would only mean that the yuan too gets weakened because of dollar depreciation. Since China represents such a large part of the trade gap, it seems that simply devaluing the dollar will not achieve the intended result. But the US is trying out another route.
This route includes a recently approved Bill, which if passed into law, will enable US legislators to levy tariffs on goods imported from countries found to be engaging in unfair trade practices, including artificially depreciated exchange rates. The premise is simple?if American manufacturers can?t compete on an exchange rate basis, then the legislators will price exported goods out of the market. This is no doubt aimed directly at China and is just the latest skirmish in what could easily become a much wider battle.
Trade wars between two major economic powers would be a loss-loss proposition. One does not win a trade war so much as one loses less. Nor would a trade war solve the US?s underlying problems. It?s simply a terrible proposition even if there are legitimate grievances against China. However legitimate they are, a trade war is a horrific way to try to fix them.
The author, formerly with JPMorgan Chase, is CEO, Quantum Phinance
