China, Foreign Trade and the Yuan: Be careful what you wish for… Part IV

Recent moves by the Bush administration to punish China for America’s lack of fiscal discipline has once again underscored the US’s inability to look ahead to consequences of its foreign policy. Iraq, of course, is the most outstanding failure, and now we are faced with another colossal blunder, this time with the China policy.

The US contends that a) increased textile imports from China and b) the Yuan peg to the dollar are endangering the US and global economy. Solution: restrict textile imports from China and float the Yuan. Really?

America’s indebtedness resulting from spending more money than it generates in revenues has placed $1.98 trillion of the $4trillion in US Treasury notes in the hands of foreign investors. Japan, the largest holder accounts for $680 billion and China $224 billion. In addition, China buys dollars to ensure its currency, the Yuan, stays at about 8.3 to the dollar, where it has been fixed for nine years.

The U.S. current account deficit widened every quarter last year, to reach an unprecedented 5.6 percent of the economy at the end of the year, while the U.S. federal budget deficit grew to a record $412 billion.

The US needs the inflows, the purchases of Treasury notes to finance its current account deficit. Without ongoing purchases of US Treasury notes the US would literally go broke. There is not enough money in the treasury to pay America’s bills and interest payments on those outstanding notes, or, if you like, America’s IOUs.

If China were to cash in their bonds and demand payment in gold rather than fiat US currency, what would happen to the Dollar? Gold prices? the Yuan? At current prices there is not enough gold in existence to pay off all of China’s holdings of US Bonds. Because of a shortage of freely traded and available gold inventory, prices would likely need to increase by perhaps 8 times or more to make enough gold available to pay China. Buy gold now!

If China wants to cash in their US Bonds, the most likely scenario is that the US will merely print more Dollars as needed and voilà, skyrocketing Inflation.

Although such action by China is not presently in the cards, if China were pushed to the wall, its ace would be the treasury notes. Cashing them in would have a greater negative impact on the United States than a nuclear strike.

Restricting Chinese Imports
If the US stops buying Chinese products, then US prices for products manufactured in China will go up – again big time inflation. As for textiles specifically, limiting only Chinese exports to the US will not stop the inflow of cheap textiles. No action has been taken to reduce the import of textile products from Egypt, Latin American and African exporters of products at prices lower than those of the US textile industry, so how will simply reducing Chinese exports alleviate pressure on the US industry?

Wal-Mart in 2004 estimated purchases from China to reach $18 billion. Think of the impact of a significant increase on prices of the world’s largest retailer. One estimate has it that 80% of microwave ovens in the world are produced in China; China became the biggest producer of mobile phones, colour TVs and monitors in the world last year. The statistics showed that the nation’s output for these products has respectively accounted for 35 per cent, 40 per cent and 55 per cent of the world’s total.

The Yuan
If China chooses, or is pressured , to float the Yuan, the US dollar could fall as the Yuan rises. Once that happens, prices of Chinese imports could increase more, as will prices for those products in the US – higher US inflation.

If the Dollar falls enough, other countries that currently hold Dollars as central bank reserves, could decide to bail out of the Dollar so it does not drag their own currencies down. Even countries that simply peg their own currencies to the Dollar may decide to allow their currencies to float. The most likely US financial defense would be to raise interest rates significantly.

One considered opinion on the net effect of appreciation of the Yuan by an economist is, “China gains its comparative advantage by low material and labour cost, highly efficient machinery as well as good quality control system. Hence, the appreciation of the Yuan would not exert too much impact on China’s comparative advantage and the US demand for Chinese exports. Besides, China’s share in the US total trade is only about 10%, and even if the Yuan appreciates by 20%, the real effect reflected on the US current account in dollar term will only be about 2%, which is too small to influence the US current account imbalance and relieve its unemployment pressure.”

It would appear then that China holds three trump cards: (1) Remove Yuan peg to the Dollar (US inflation), (2) Cash in their US Bonds (US interest rate rise, US inflation or much, much worse), (3) Threaten to stop or reduce all exports to US (US mega inflation).

America’s Shock and Awe approach will work no better economically with Chiina than it has in Iraq militarily. The consequences of this ill thought out knee jerk reaction to China will have even more serious repercussions than the debacle in Iraq.


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