China and the ‘balance of financial terror’

America and China's tightly interlocked trade relations are on a knife edge. A wrong move either way could take a slice out of the world economy, says Simon Wilson

When was China's currency pegged to the dollar?

China's currency, the renminbi (more usually known as the yuan in Western countries) was fixed to the US dollar in 1953, when China was run strictly as a Soviet-style, centrally planned economy. From 1994, the yuan was pegged to the dollar at a fixed rate of 8.28 per dollar.

In July 2005, China's central bank, the People's Bank of China (PBOC), revalued the currency by 2% in July 2005, to 8.11. The yuan was also allowed to float within a narrow band around this level up to 0.3% per day either way and the dollar peg was swapped for a basket of currencies, though still dominated by the dollar.

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What has happened since then?

Since July 2005, the rate has changed little strengthening from 8.11 at revaluation to around 8.0 today. But the fluctuations in the rate are (by their own modest standards) becoming more volatile, culminating last month in a limit-testing 0.28% one-day fall.

This suggests the PBOC is deliberately fostering volatility to encourage firms to hedge their positions (as is standard practice in developed capitalist economies) in order to create a more liquid foreign-exchange market. Some analysts believe China is preparing to allow a more speedy appreciation in its currency's value either by letting it edge to the top of the band more often, or by widening the bands in the near future.

Why does this matter?

Because the dollar/yuan exchange rate is the source of great tension between Washington and Beijing, and because the economic relationship between the US and China is crucial to the global economy. In short, the US is importing extensively from China and at the same time borrowing heavily from it to finance those purchases.

The result is a massive US trade deficit that pushes the dollar down and a shift in power towards China, which has built up a near-trillion-dollar hoard of foreign reserves. It is not known how much of this $1,000bn is held as US Treasuries; official US figures show $326bn worth held directly by Chinese investors, but much more is held indirectly (for example, through London banks).

So what's the problem?

Washington politicians see China's de-facto dollar peg as unfair and destructive to US manufacturing and have threatened 27.5% tariffs on Chinese imports. Beijing hints that if pushed too hard too fast, it could shift out of US Treasuries, triggering an all-out collapse in the US dollar and (at worst) a global loss of confidence in dollar-denominated commodities and assets and a global slump.

This makes China and the US hugely interdependent, but could put them on a collision course a situation memorably described by ex-US treasury secretary Lawrence Summers as "the balance of financial terror".

Would a revaluation cut America's trade deficit?

Only very marginally. In the eyes of protectionist US senators, the mere fact that America ran a $202bn trade deficit with China last year seems strong evidence that China's currency must be undervalued. But in fact, China has accounted for only about a third of the increase in the total US deficit over the past five years and much of that is down to China's increased attractiveness (since joining the WTO in 2001) as a place to assemble goods made elsewhere in Asia.

So while China runs a big surplus with the US, it runs deficits with other Asian countries from which it imports components and plant. Similarly, while America imports more from China, it imports less from the rest of Asia. What's more, China accounts for only 10% of America's total trade, so a 10% revaluation of the yuan would reduce the dollar's trade-weighted value by only 1%.

The real cause of the US trade deficit is that the US consumes too much and saves too little. A stronger yuan won't change that.

But is a revaluation of the yuan in the US's interest?

Opinion is divided, but more and more economists are pointing to the downside of a stronger Chinese currency for the US. Most obviously, cheap Chinese imports help hold down inflation, and hence interest rates. China's vast purchases of US debt in the form of Treasuries and other government agency debt purchases designed to protect China's competitiveness by holding down the yuan have helped prop up America's reckless public finances and kept bond yields lower than they would otherwise have been.

By contrast, a Chinese revaluation would create inflationary pressures in the US and the likelihood of higher interest rates while a smaller Chinese surplus would reduce China's appetite for US bonds.

What does China want?

Although a trillion-dollar reserve looks like a nice problem to have, China is not in an easy position. First, it is no small feat to absorb $17bn a month in foreign currency into an overheating economy with a creaking and underdeveloped banking system.

Second, China's long-term purchases of US dollars in order to keep the yuan down mean it has fuelled US consumption rather than a Chinese consumer market that could drive long-term growth, and is now trapped in a situation where it cannot afford to let the dollar fall too much.

Equally, given the scale of its trade surplus and reserves, it would be hard to diversify its dollar holdings by buying other assets (such as gold, oil or currencies) without sending prices soaring. Any diversification would have to be marginal and gradual.

For Beijing, the best way out of this dilemma would be a more flexible currency and a slow appreciation of the yuan two policy objectives that the growing volatility in the exchange seems designed to promote.