The China–U.S. Exchange Rate War

All indications point to the U.S. strongly pressuring China on the USD-RMB exchange rate, a sign that a currency battle is at hand. China should not only be defensive but also take proactive actions and measures. Early initiative can result in positive effects on the Sino–U.S. economic relationship and prevent the proliferation of a trade war.

The Ministry of Commerce recently released a report stating that the U.S. trade deficit with China did not increase in January. In fact, compared to the nearly $21 billion deficit of January 2009, there was a significant decrease. Nevertheless, during his March 11th speech at the annual conference of the Export-Import Bank, Obama spoke out on the exchange rate and put pressure on China. He pointed out, “[E]verybody has got to rebalance. Countries with external deficits need to save and export more. Countries with external surpluses need to boost consumption and domestic demand.” He called on China to transition to a market-oriented exchange rate and to be a force in global rebalancing efforts. This indicates that in order to reduce the trade deficit, the United States will strongly pressure China about the exchange rate. The battle has begun.

In his State of the Union Address in January, Obama pointed out that U.S. exports will double within five years and create two million new jobs. During this financial crisis that led to a decline in purchasing power, the biggest hope for increasing U.S. exports is undoubtedly China. Therefore, the main reason America emphasizes the exchange rate issue is to pave the way for expanding the amount of U.S. exports. At the same time, the U.S. government is speeding up the development of a series of measures against China, including anti-dumping laws, countervailing sanctions and special protection measures to reduce the importation of Chinese goods.

The United States May Identify China as a “Currency Manipulator”

As early as April this year, the United States may identify China as a “currency manipulator” under the Omnibus Foreign Trade and Competitiveness Act of 1988. Obama has made it clear that the U.S. government must decide whether the Semi-Annual Report on International Economic Exchange Rate Policies will include this designation. If China were to be labeled a “currency manipulator,” the U.S. Congress would take substantive action against China. Congress may pass a motion stipulating that if the RMB does not appreciate by 30 percent, the U.S. would impose a punitive tariff of 30 percent against all Chinese goods. This would deal a severe blow to China–U.S. trade.

The U.S. Department of the Treasury has never undertaken a countervailing duty investigation against exchange rates. These investigations have only included preferential bank loans, export tax rebates and similar practices. Since last November, however, the Treasury Department has received considerable pressure from Congress on the issue. Congress has requested that the Treasury Department launch an investigation into imported coated paper. Faced with continued pressure from Congress, the Treasury Department relented. In a preliminary ruling on March 2nd, the Treasury Department reported that there were indeed subsidies involved in Chinese coated paper exports to the U.S. and issued a four to 17 percent countervailing duty margin.

In addition, the Treasury is considering including the manipulation of the RMB exchange rate in its countervailing investigations. If it determines that the RMB has been undervalued through subsidies, tax rate increases will be announced and as a result, exchange rate subsidies will be considered in all future cases. This would ignite a trade war.

RMB Appreciation is Not the Cure

Many Americans believe that an RMB revaluation would reduce the competitive advantage of Chinese exports. At the same time, the value of China’s holdings of Treasury bonds would also decrease.

In fact, an RMB appreciation would only cause trouble to Chinese exports and would not offset the price disadvantage of U.S. products, the root cause of which is high production costs. Of all the currencies of major Asian exporting countries, if the RMB is the only one to appreciate, the U.S. would see a reduced share of imports from China. Soon the ASEAN and other South Asian countries would fill the void left by China. Even if U.S. factories produced at maximum capacity, the price disadvantage of U.S. goods would eventually lose out to the competitive edge of ASEAN and South Asian goods. In a nutshell, the overall U.S. trade deficit problems still remains.

The reason the United States want to revalue the RMB is not only to fix the trade deficit with China but, more importantly, to attempt to repeat the affects of the Plaza Accord and interrupt the rapid growth and momentum of the Chinese economy. The outcome could be reminiscent of what happened to the Japanese economy a while back.

China should not only be defensive but also take proactive actions and measures. Early initiative can result in positive effects on the Sino–U.S. economy and will prevent the proliferation of a trade war.

Proactive Action with Positive Measures

Capital markets should be opened in order to bring the advantage of cheap capital to U.S. companies. The Shanghai Stock Exchange should be launched as soon as possible. This will provide more choices to Chinese investors and strengthen the country’s economic relations with U.S. companies. China should also reduce tariffs on certain imported goods in order to increase U.S. imports, especially automotive products. A substantial increase in the amount of U.S. automotive imports would change unions’ attitude towards China. Reducing tariffs would also open the agricultural product market of the U.S., which significantly impacts the U.S. political arena. This would take the pressure of the agricultural industry and community off of the Obama administration. Although there may be some negative impact on the Chinese agricultural sector, these issues can be solved through financial support.

The economic and trade relationship between China and the U.S. has changed significantly from what it was a decade ago. It was originally a one-side situation, but now both sides interdependent in economic and international affairs. The U.S. still hopes to work closely with China on issues such as maintaining international financial stability, combating international terrorism and preventing the proliferation of nuclear weapons to ensure the stability of the Korean Peninsula. China also has the ability to counter the strength of the U.S. For example, China’s holdings of U.S. Treasury bonds have aroused speculation over the past two months. The two countries have established more coordinated negotiation channels, such as the Joint Commission on Commerce and Trade. In the long term, with proper handling of possible frictions and conflicts of interest, mutual benefit can be ensured.

Cooperation will benefit both countries, and strife will harm both. If the U.S. blindly intensifies trade friction with a substantial increase in tariffs on Chinese goods in order to force RMB appreciation, China will certainly take countermeasures and not give in. The trade wars could worsen and affect the export of U.S. goods to China. In the end, neither side wins.

Hopefully, Chinese and U.S. leaders have the wisdom and determination to handle this situation in a rational and constructive manner. It is also important that the U.S. not get caught up in a currency war that could result in a huge setback to Sino–U.S. relations.