John Rapley
THIS WEEK, the US Treasury Department gave its sternest warning yet to China that its currency regime had to change. This may seem an arcane matter, but the brewing conflict could have profound consequences for the world economy.
For the last decade, China has maintained a currency-peg. The Chinese government has set a narrow band within which its currency can move vis-a-vis the US dollar, then intervened whenever the yuan has strayed outside that band.
China's re-entry into the world economy, as we all know, has attracted huge amounts of foreign investment and demand for Chinese exports. This influx of foreign money has driven much of the Chinese boom. Ordinarily, as foreign money flowed into China, rising demand for the yuan would drive up its value.
UNDERVALUED
However, the Chinese authorities have been eager to prevent an appreciation in their currency. For as long as the yuan remains undervalued, Chinese exports remain cheap in the outside world, and particularly in the U.S. Eager to export their way to economic growth, China's leaders have assiduously sought to keep the yuan from moving outside its narrow band.
To do this, they have used their resources to inflate the value of the dollar. Given all the American money flooding into China, the Chinese have accumulated a mountain of dollars. Rather than convert them into yuan, they have used them to buy U.S. securities, and especially U.S. treasury paper. This steady demand has preserved the value of the dollar, and thus supported a burgeoning U.S. trade deficit with China.
The Americans are not happy. First of all, cheap Chinese goods have been eliminating U.S. jobs. As a result, the call for protection against Chinese imports has been rising. Beyond that, the U.S.'s trade deficit, which to some looks out of control, could eventually prompt a crash in the U.S. With asset prices rising, money has been pouring into America from around the world. Almost all economists say the situation is unsustainable. For the first time ever, the U.S. economy now finds itself in the position Asia's economies faced nearly a decade ago: booming, but in danger of crashing, which in turn could see everyone rushing for the exits.
In theory, the U.S. trade deficit would by now have reduced the value of the dollar. This, in turn, would have decreased imports, boosted exports and augmented interest rates. Rising interest rates, in turn, would have slowed demand and raised savings in
the U.S. In short, the economy would have found its way back to equilibrium.
However, the needed adjustment has not taken place. The Federal Reserve Board, the U.S.'s version of a central bank, has been trying to tackle the trade deficit by reducing demand. It has also been trying to slow the economy's growth, with its attendant risks of rising inflation, by raising short-term interest rates.
The problem is that while it does this, the Chinese central bank is buying up U.S. Treasury paper. This has actually driven interest rates down in the US. So while the Fed is trying to restrain demand, the Chinese central bank is busily stoking it. Falling interest rates are encouraging Americans to keep borrowing, buying houses and investing in the stock market.
GAME OF CHICKEN
In effect, the Chinese and U.S. central banks are engaged in a game of chicken. But if it goes on much longer, there is a risk of a speculative price-bubble inflating in the U.S. Roaring demand for houses, in particular, has apparently driven prices beyond rational levels across much of the country. The longer the adjustment is postponed, the more painful it will be when it comes.
Meanwhile, the U.S. Congress is ratcheting up pressure on the Chinese. If Beijing does not revalue its currency soon, it is threatening to slap tariffs on a range of Chinese imports. The risks of a trade war now hang over the world economy.
It is looking like the Chinese may soon give in and revalue their currency. But the fear is that Beijing will offer too little, too late. In the meantime, we are witnessing the bizarre spectacle of American's central bank battling the Chinese one on its own turf. For now, at least, it is losing the fight.
John Rapley is a senior
lecturer in the Department of Government, UWI, Mona.
