Watch April 15 2010: simmering tensions between US and China

March 23rd, 2010

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April 15, 2010 is a day worth watching. It will be the day when the US Treasury will issue a report, designating whether China is a “currency manipulator” or not. While the repercussions of China being labelled a “currency manipulator” are worrying, this issue is hardly new. In fact, as we wrote in US shooting own foot with tariff on Chinese goods three years ago,

At present [April 2007], the US Congress is simmering in antagonism against China for her trade surplus against the US. They see China as a convenient scapegoat for America?s economic woes, accusing her of misconducts that includes currency ?manipulation,? unfair trade practices and so on.

For the past three years, both sides seem to be going round in circles regarding the Chinese currency peg issue. It seemed that China was repeatedly on the verge of officially being accused of currency manipulation, only for that charge to be withdrawn from the final assessment. Based on statistical probability, the chances for that charge to be issued again are slim. But as our long-time readers know us, we are no fans of using statistical probabilities to ‘predict.’

One thing is clear: the pressure for officially labelling China as a “currency manipulator” is much strong today than three years ago. Firstly, President Obama is more inclined towards that than former President Bush. Secondly, the US economy today is at a more advanced stage of deflation (i.e. unemployment, fall asset values, economic stagnation) than three years ago. Thirdly, mid-term elections are coming and consequently, there are a lot of domestic pressures for Obama to get tough on China.

In the face of further economic stagnation, the US is sliding downward towards mob rule. With a clear understanding of Irving Fisher’s debt deflation theory of the Great Depression, we can easily understand that for an economy heavily addicted to debt, all it takes for the economy to slow down is a slowdown in credit growth. As we wrote in Australia?s credit growth is still falling,

Marc Faber once said that for an economy that is addicted to debt, all it needs to tip it into a recession is for credit growth to slow down- no contraction of credit is required. Also, as Professor Steve Keen explained, at this stage of the debt cycle, the aggregate spending in the economy is made up of income plus change in debt. In the absence of income growth, a slowdown in credit growth implies declining aggregate spending by the private sector.

Currently, the US is in the midst of a generational shift in culture/mindset from borrowing to saving. That is, in economic terms, the US private sector is de-leveraging. The symptoms of de-leveraging will be asset price deflation, economic stagnation, rising unemployment and so on, which will be counteracted by increase in government debt and spending (which itself is limited by market’s confidence in government debt).

In lay-person’s terms, the US is suffering because they are on cold turkey from debt. In contrast, the Chinese are postponing their pain by going further into debt (i.e. policy of inflation and force-feeding of credit into the economy). This result in an illusion that America is suffering while China is ‘prospering’ (which is worsened by Chinese government’s propensity to doctor the figures to look good in order to save ‘face’).

But the mob wants to find a scapegoat to blame for their woes. It so happens that the most convenient scapegoat is China (specifically, China’s policy of artificially holding its currency down) because at this point of the cycle, China is looking very good. It is perceived that this policy worsen America’s unemployment rate. By implication, it is perceived that with China’s official unemployment rate much lower, China is ‘prospering’ at America’s expense.

The problem is that if China is to acquiesce to America’s demands today, it will not solve the America’s problem tomorrow. In fact, the immediate effect will be to worsen America’s (and China’s as well) economic woes. Price inflation will rise and market based interest rates will go up, worsening America’s debt deflation problem. The reason is because the Chinese currency control had been in place for too long and that resulted in long-term structural changes to both the US and China’s economies. Removing the control immediately means that both economies will have no time to adjust, compounding the current level of pain for both sides.

For China, if the words of its Vice Commerce Minister Zhong Shan are accurate, the profit margins of many Chinese exporters were less than 2%. By appreciating the yuan, many Chinese exporters will go under, which by implication will have serious impacts on unemployment in China, and by extension, on social stability.

SEO Secrets e-bookBut as we wrote before in Chinese government cornered by inflation, bubbles & rich-poor gap, China has their own inflation problem that will eventually threaten social stability. They are already taking tentative steps to rein in inflation (see Is China going to allow its banks to fail in the upcoming (potentially gigantic) wave of bad debts?). Letting their yuan appreciate is very likely part of their overall plan to re-balance their economy. It will happen eventually. But the problem is, the Chinese wants to do it gradually. But the US politicians, on the other hand, want China to do it quickly in order to appease their electorates. Already, we have American economists like Paul Krugman (who is of the same ideology as Ben Bernanke with regards to money printing to solve economic problems) writing inflammatory articles and egging for a economic fight with China.

So, April 15, 2010 will be an interesting date to watch. If China gets labelled as a “currency manipulator,” then trade tensions jump up a level. If left unchecked, that will result in trade war. If trade war is left unchecked, the gloves will come off and there will be more unsportsmanlike actions from both sides (i.e. covert dirty war). If dirty war goes unchecked, there is a risk of shooting war. We are not saying all these things will happen- our point is that there will be a time and sequence for things to happen.

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  • Pete

    Great article CIJ! An excellent read 🙂

    It seemed that China was repeatedly on the verge of officially being accused of currency manipulation, only for that charge to be withdrawn from the final assessment.

    Did the American's catch a glimpse of themselves in a mirror? 😉 (couldn't help it)

    The US sounds like it is playing a silly game here. Although that said, China is too. Have they passed the point-of-no-return in regards to sound economic policy that could save their respect economies? I think they both did years ago.

    Seems like a race to the bottom now. The US is leading China, although a significant portion of Europe seems to be heading off the charge, determined to be first.

    I wonder if this is the 'black swan' that will trigger the markets. I can picture it now, US blames China, markets get upset, Greece and the other PIIGS make a scene, markets get even more upset, the US makes a scene and then so does China. Like dominos.

    And my guess is that Australia would be flattened. Interest rate rises, tightening credit and less demand from China would bludgeon us.

    Going to the next step – if China is no longer the cheap manufacturer, then who is? If trade relations break down, then who makes all the stuff China makes? Will we start to make things domestically? Or will someone like India try and pick up where China left off? Will China fight a price-war to the grave?

    There could be positives to come from it all. Domestic industry won't be as efficient, but it will mean we are a bit more self-sufficient. Although the cost of living would skyrocket.

  • Hi Pete!

    Going to the next step – if China is no longer the cheap manufacturer, then who is? If trade relations break down, then who makes all the stuff China makes?

    China's cheap labour is not getting cheap any more, thanks to domestic inflation. The baton of cheap manufacturing may be passed down to countries like Vietnam.

  • ted

    Fascinating problem CIJ! I remember reading Jim Rogers saying (was it in A Bull in China?) that he cannot understand why China still keeps the peg, as he seems to believe that they can weather any short term exporter pain and that the RMB is ultimately a much better currency than the USD. It seems the Chinese are not so sure of that. Could it be that special interests within China – the exporter lobby from the coastal provinces – are behind the continuation of the peg? As you've pointed out before, the peg is a long term poison for China because they are importing helicopter Ben's mad inflation and destroying their own savings.

    This is the key point of interest for me, and I don't have an answer to it: can the RMB compete with the USD for reserve currency status?

  • Hi Ted!

    It seems the Chinese are not so sure of that. Could it be that special interests within China – the exporter lobby from the coastal provinces – are behind the continuation of the peg?

    Good question. We guess no one can really know the answer. Our guess is that the powerful guys inside the inner recess of the Chinese government are probably debating among themselves. It is even possible that there're diametrically opposed factions internally within the higher echelons of the Chinese government while they present a united front externally.

    That could explain why they seemed to be 'unsure.'