China's currency revaluation and effects on global economics

¶ … Chinese Currency Issues

Over the last several years, the issue of China's currency revaluation has been increasingly brought to the forefront. The reason why, is because many of the developed nations (i.e. The United States and the European Union) are experiencing unusually large trade deficits, while China is seeing trade surpluses. This is important, because issues such as currency disputes can have ripple effects on the world economy. Where, the actions taken by one major player can cause various imbalances to occur elsewhere. A good example of this can be seen with recent quantitative easing measures taken by the Federal Reserve. What happened was the as the stimulus has begun to wane over the last several months, many economists have begun to question if the world would experience a second (double dip) recession. This is where the economy will move into a stage of zero growth and will then begin contracting. To avoid this kind of situation, the Fed would begin to aggressively buy U.S. Treasuries. The idea was that this would drive down long-term interest rates, helping to spur inflation and jump start the economy. The problem with this kind of action is that it will force the currencies of many developing countries to rise sharply. This is problematic in the case of China, as these kinds of actions could help destabilize their currency and the economy. Evidence can be seen with comments from Former Fed Chairman Alan Greenspan in the China Daily newspaper. Where he wrote, "Many in China fear that removal of capital controls that restrict the ability of domestic investors to invest abroad and to sell or to purchase foreign currency, which is a necessary step to allow a currency to float freely, could cause an outflow of deposits from Chinese banks, destabilizing the system. Financial instability in a big emerging economy (such as China) would present a risk to the global economic outlook." ("RMB Floating Could Be Risky ") This is significant, because it shows the challenges that are faced when addressing any kind of currency issues. As the policy decisions by one central bank could have ripple effects around the world. To fully understand the different views on this complicated issue requires conducting a detailed analysis of: the reasons why developed countries (such as the U.S.) wants the currency to rise, how the two countries (the U.S. / China) have reacted to these views, what will be financial consequences of these actions and what will other nations do to defend their own interests / currencies. Together, these different elements will provide the greatest insights as to the long-term impact that the currency debate will have on the global financial system.

The Reasons Why the U.S. Wants the Yuan to Rise

From the perspective of United States, if China were to allow the yuan to float freely, it would have a dramatic impact upon the U.S. economy. This is because increases in the yuan, would play an interconnected role in helping to adjust the obvious imbalances (from the government using the dollar peg). The biggest reasons why they are pushing China so hard on this issue includes: it can make American products more competitive in Chinese markets and it can dramatically reduce the trade deficit. ("Paulson Promotes Letting Yuan Rise")

When you look at the first reason (a rising yuan can help make American goods more competitive), it is clear that if the Chinese government allowed the currency to float freely against the dollar it would see an immediate appreciation. This is because the peg that is being utilized by the government is artificially undervaluing the yuan. When you remove this cap, all of the pent up demand will cause significant price increases in the currency. At which point, American corporations will begin to see their different goods and services more competitively priced in these markets. Once this takes place, it means that many Chinese consumers will begin purchasing various American products, because they are more affordable. Over the course of time, these increasing profits will translate into a positive trade surplus with China. As the lower priced American products, are helping to fuel an increase in imports (causing the trade deficit to decline). This is significant, because if the United States can persuade China to allow the currency to float freely against the dollar. The various imbalances in the world economy would naturally adjust. This, (the U.S. argues) would provide the most stability for the global financial system, as the markets should determine the best rates for currencies vs. The central banks. ("Paulson Promotes Letting Yuan Rise")

What will be the Financial Consequences of these Actions?

There are a number of different financial consequences that could result from these actions the most notable include: a currency war, maintaining the status quo and China agreeing to the let the yuan float freely against the dollar. A currency war is a very realistic possibility at this point. The reason why, is because the actions taken by the Federal Reserve (the purchasing of U.S. Treasuries) will cause the price of dollar to collapse. This will force foreign investment capital to dry up in China. As the falling dollar will allow inflationary pressures to increase and it will put strain on the banking system. These two elements could indirectly force China to allow the yuan to increase against the greenback, as this action would help to alleviate the pressure that it will be facing. However, if no action is taken and the peg remains in place, this could help to fuel hyper inflation, which would cause China's economy to overheat. This is significant, because one could argue that the actions taken by the Fed may be inadvertently starting a currency war. Where, China may be forced to retaliate or take direct measures to allow the yuan to float freely. As far as retaliation is concerned there are host actions that China could take to include: selling their holdings of U.S. Treasuries, increasing tariffs / trade barriers and making it more difficult for American-based businesses to operate. (Braningan) If this happens, it could throw the world economy into a depression. (Parsons) The challenge going forward, will be determining how the Chinese government will react to these events. As one could easily argue that the U.S. is taking unilateral action, to place pressure on China and help to stabilize its own economy. ("RMB Floating Could Be Risky") (Parsons)

A second possibility is that the status quo could be maintained. This is highly unlikely as the U.S. And China, have been negotiating on this issue for the last several years. The fact that the U.S. is facing, the possibility of another recession and the increasing budget surpluses of the Chinese government are making this situation worse. As a result, the status quo will be changing at some point in the future, due to these two elements. Recent evidence of this can be found with the G20 summit, as the issue of currency and interest rates contributed to the heated atmosphere. (Parsons)

A third possibility is that China could remove the peg from the dollar and allow the yuan to float freely. This is questionable at best, the reason why is because such a move could cause a large readjustment in the economy. In order for this to happen, it would more than likely take some kind reaction after a major economic catastrophe. For example, if there was a currency war and a host of protectionist measures were implemented, resulting in a depression. China may take the peg off of the dollar, as there would be limited negative implications (at that point). A second option is that they could find some kind of benchmark (i.e., a basket of currencies) and use that for their peg. This could accomplish the same objectives of removing the peg from the dollar without the negative implications. (Parsons)

What will other Nations do to defend their own Interests / Currencies?

If a currency war were to begin between the U.S. And China, it would have negative implications around the world. What would more than likely happen is both developed and developing nations would engage in various protectionist practices. Where, every country would be taking unilateral actions, to protect their own economies at the expense of their trading partners. Once this occurs it could create a similar situation, as to what took place in the 1930's. This is a realistic possibility, as the heated animosity over the actions taken by the Federal Reserve and those of China could spark a currency war. At which point, each nation will begin to look out for their own self-interest. A good example this can be seen with comments from British Prime Minister David Cameron who said, "Failure by the G20 to accomplish some sort of global accommodation could lead to a return to what happened in the 1930s: protectionism, trade barriers, currency wars, countries pursuing beggar-thy-neighbor policies; trying to do well for themselves but not caring about the rest of the world." (Parsons) This is significant, because it shows how once a currency war begins, it could force all countries to engage in practices that will protect their own self-interest at all costs.

Clearly, the way the news is presented can have a dramatic impact upon how various policy decisions are determined. In the case of China and revaluing of its currency, this would have negative impact upon how the issue is presented. Where, each of these different newspapers; will present these views from a perspective reflecting the country itself. What is noteworthy about these reports; is how certain papers will take Western leaders (like Allan Greenspan) and use them to support their own views. As a result, this can make each of the different newspapers (in either country) reflect the perspectives of the government. This has influenced my opinion on currency issues between the U.S. And China. As it has helped to improve my understanding of why the Fed is taking such actions. At the same time, it has also helped me to think critically about, why China is so reluctant to remove the peg off of the dollar. When you put these different elements together, this highlights how the heated emotions on this issue will more than likely result in some kind of currency war. The reason why is because the actions taken by the Fed, have fueled the deep ceded negative emotions that both countries are feeling. At which point, the odds increase dramatically that some kind of currency war will take place in the future.