Sparring of words over the RMB

All focus has been on the “unusually uncertain” comment by Bernanke, though the hearing touched on Chinese currency issue as well. As reported by Reuters:

Under questioning by one of those lawmakers, Senator Sherrod Brown, Bernanke answered “yes” when asked if he stood by a statement he made several years ago calling China’s exchange-rate policy an effective subsidy.

When pressed how much China’s yuan was undervalued, Bernanke said: “The numbers that you see in the literature range between the 10 and 30 percent range.”

As November approaches, it’s only expected that the US will push harder on this front. But are they going to get their wish fulfilled? This one is from AFP:

“The exchange rate of the currency will decline if it becomes necessary to support exports,” Zhou [Qiren, a member of the central bank’s monetary policy committee] told the Asahi Shimbun [of Japan] in an interview, according to the paper’s English-language website.

I don’t know about you, but I think Chinese exports will weaken substantially in H2 as the US non-recovery recovery sputters and European austerity kicks in. China’s own stimulus is also losing steam, so much so that the banks are quietly relenting on strict lending restrictions.  If you think China’s going to become a good Samaritan in this environment, I’ve got a bridge to sell you.

Andy Xie believes that trade war can be averted

Xie is my favorite China economist by far. He penned an article in the New Century magazine, discussing the probability of trade war and calling for more rapid interest rate hike. The piece is in Chinese so you’ll have to bear w/ my translation.

Chinese exports to the US are mostly owned, designed, and marketed by large American MNCs. Across-the-board tariff increases will cut their profits, leading to collapse in the equity market, which in turn will cause a second-dip in the real economy. The current US government doesn’t even have gust to prosecute those that blew the bubble and wrecked its economy, it will in no way dare to hurt its economy this way.

Xie is more optimistic than I am. People are not entirely rational and Washington is looking for blood this time. Does Obama strike you as a staunch free-trader? Not to this blogger anywayz. The only thing that might hold back the US from a full-scale trade war is a prospective rise in interest rate. Last week’s lousy treasuries auctions are more helpful in pulling us from the brink than any other rational argument.

To me a key event to watch is the April 12 summit in Washington over nuclear nonproliferation. What does this have anything to do with the economy? Well, nation states have other business to look after besides things economic. The US has been trying to talk Hu Jingtao into attending the meeting personally. Giving the Chinese emphasis on face, I doubt he’ll go if there’s any chance that China will be named a “currency manipulator” 3 days later.

The 2nd half of the article relates to interest rate and Xie is calling for a sooner hike rather than later. He sees a huge bubble in the Chinese property market and wants tighter monetary policy.  One of the arguments against interest rate hike is that this will attract more hot money inflow to an already overheating economy.

Already there are a large amount of hot money inflows into China. What they are chasing is not interest income, but a bubble. If China hikes interest rate, the hot money may actually leave worrying about the upcoming burst. This will lessen the RMB’s pressure to appreciate, rather than intensifying it.

This may be true, if the interest rate hike is drastic enough. However, given the mildness of  the world recovery and the Chinese authorities’ natural and historic tendencies to moderation, I doubt the hike will be sharp enough to scare off further hot money inflows. Creating a one-side bet against the RMB a la 2005 is not desirable from China’s perspective. I think China most likely will tighten through controls on new bank loans, unless inflation surpasses the 3% target. Then China may feel the need to utilize the interest rate sledgehammer, or maybe even currency appreciation.

What will China do in a trade war?

Many people still seem to believe that the recent saber-rattling is just of the normal type, that both sides scream a lot but will eventually see the light and settle down to talk. But the mood in both the US and China are a lot more somber this year. Call me a pessimist, but I think a showdown in trade is inevitable.

What Washington will do is quite obvious. What’s the point of labeling someone a currency manipulator if you can’t stick punitive tariffs to its exports? The question is what China will do in retaliation. The folks calling for blood now seem oblivious to the cost right now. Maybe they don’t know, or maybe they just want to lash out at the “culprit”.

Would it hurt China? Oh, you bet! Despite all the talk of developing a domestic economy, the Chinese economy is 40% export. Although China is a lot less dependent on the US as a key customer now compared to a decade ago, any MAJOR customer is still important in this environment.

The question is at what cost? What will China do to retaliate? The natural suspect of dumping Treasuries is usually brushed off as not feasible since it will cost China in terms of capital loss to its existing holdings. What this argument fails to note is that the Chinese do NOT buy treasuries out of their kindness, out of love for Washington, or even out of their freewill, but out of necessity from holding too much excess US dollars coming from their trade surplus. If export to the US is slapped with punitive tariffs, China’s trade surplus will naturally shrink, leaving it with less dollars which in turn will translate into less purchase of treasuries.

Now of course, lost business to China will naturally go somewhere else. So someone somewhere will eventually end up with excess dollars and buy treasuries. But this trade adjustment will take some time and there’s no telling how much they actually save up from the trade to buy treasuries. Theoretically they could have spent it all. Vietnam, a most likely beneficiary, actually runs a trade deficit. On the other hand, the impact on interest rate will be immediate, especially given the aggressive borrowing schedule from the Treasury. Already China is reporting its first trade deficit since 2004 for March, and we are seeing turbulence in 10-yr yield. Could this be a harbinger of catastrophe to come?

In this scenario, China doesn’t even have to do anything. This is just the natural outcome from diminishing trade surplus. As for the hope that economic pain will push China to revaluate, keep on dreaming. If trade collapse, the natural order of things is to devaluate, isn’t it?

In the end, it will come down to a masochistic competition of pain tolerance, and I’m not holding my breath for a people steep in entitlement.