Today's comment is by Jack Crooks, our Currency Director and editor of Crooks on Currencies and The Money Trader.
Remember the acronym MAD, or "Mutually Assured Destruction?" This term was used during the Cold War period to describe the inevitable result if either the U.S. or the Soviet Union launched nukes at each another.
This policy of "mutually assured destruction" reminds me of today's sometimes rocky relationship between the U.S. and China, as both nations vie for economic advantage across the globe.
U.S. policymakers are growing increasingly impatient over the rising trade deficit with China. They want some action. That's why U.S. economic heavyweights broke bread with their counterparts in Bejing this week. The team of U.S. policymakers was led by Treasury Secretary Hank Paulson, Fed Chairman Ben Bernanke, and U.S. Trade Representative Susan Schwab.
There is lot at stake. And you can bet both parties know that the threat of "MAD" underlines this important economic relationship. Both parties seem to be wielding this threat for bargaining power. A wrong move by either party could have a dramatic effect on all asset markets across the globe.
So What's All the Fuss About?
The fuss is about jobs and "fair trade." And both are intertwined with China's currency policy.
Many in the U.S., especially within the newly Democrat-controlled Congress, blame China for the loss of millions of U.S. manufacturing jobs and rising trade deficits.
Specifically, they say China's policy to suppress its currency, the yuan, places undue restrictions on foreign firms trying to do business in China. And they claim China's disregard for intellectual property rights makes China an unfair trading partner. These charges have lingered for some time, but China has done little to address the issues.
In the eyes of U.S. leaders, the latest trade deficit with China, (swelling to an all-term record of US$24.4 billion in October), just makes resolving these issues more urgent. Already 27 separate trade bills are floating around Washington, to target imported Chinese goods. Any one of these bills could be unleashed if China and U.S. economic officials can't find some way to get along.
Here is how Reuters has summed up the talks so far: "China and the United States agreed to broad steps on Friday to tackle global economic imbalances as two days of talks to ease trade and currency strains ended with good intentions but modest substance." I think the U.S. Congress wants substance.
The most obvious and substantial sign of progress would be China changing its currency policy. Instead of suppressing the value of the yuan, the U.S. is pushing China to let the currency float freely on the basis of supply and demand, like the rest of the world's major currencies.
China Fears a Higher Yuan Will Whack Exports
Many economists believe China's currency is 20-50% undervalued against the U.S. dollar. You can bet Chinese policymakers lay awake at night worrying about the Chinese yuan increasing in value by 50%. China's economic growth is primarily based on its ability to export cheap goods, not domestic consumption. Chinese policymakers are afraid any significant increase in the value of their currency will whack their exports and slow China's overall growth.
U.S. policymakers believe if China's currency were allowed to trade "where it should," they would finally even out the whopping trade imbalance between the two countries. So you can see, interests in the U.S. and China are diametrically opposed. This is why Treasury Secretary Paulson is urging China to move faster on improving its domestic consumer economy.
The U.S. wants China to rev up domestic consumption, so they can let their currency appreciate. And as a bonus for the U.S., increased Chinese domestic demand would increase U.S. exports to China.
Though China's policymakers agree they need to do more on domestic front, they argue that transitioning away from an export growth model will take time. They keep telling U.S. policymakers to be patient. But, as you could probably guess, U.S. policymakers already ran out of patience.
If the U.S. policymakers get their way, China could lose some of its best customers, including 300 million Americans who can't seem to get enough of China's quality goods at discount prices. Losing access to the U.S. consumer would hammer China's growth.
But of course China's policymakers have already launched a couple threats of their own. Recently China's central bank governor mentioned they are considering reallocating some of their estimated US$1 trillion in reserves away from the U.S. dollar. And 70% of those U.S. dollar reserves are held primarily in U.S. government and agency bonds.
The U.S. dollar tanked sharply on that rumor last week. And just imagine what would happen to the price of U.S. bonds if the Chinese really started dumping their reserves. It could get ugly! U.S. interest rates would soar in response. Soaring U.S. rates would in turn hammer U.S. economic growth. And just imagine what would happen to the U.S. corporate profit outlook if China were to retaliate on trade. The U.S. stock market could crash.
Let's hope that cool heads prevail, and no one gets MAD. But in the meantime, it makes a lot of sense to diversify outside the U.S. dollar just in case China does decide to dump the greenback.
JACK CROOKS, Currency Director,
The Sovereign Society
EDITOR'S NOTE: Want to diversify out of the dollar, but just don't know how? Last month, Jack launched a currency service to help beginner currency traders diversify out of the dollar, by trading currency exchange-traded funds (ETFs). And his first position is already posting a 3.9% gain. Learn more about his service.