How Will China's Currency Moves Affect The U.S.?

By Stephen D. Simpson, CFA | October 14, 2011 AAA
How Will China's Currency Moves Affect The U.S.?



Much of the financial media may still be focused on the accelerating downward spiral of Greece or the anti-Wall Street protests in New York City, but China took a page from Glenn Close's book Wednesday and reminded the markets that it will not be ignored. The real question, though, is whether China's currency combat techniques and prickly sense of sovereignty represent a clear and present danger to U.S. businesses, consumers and investors.

TUTORIAL: Foreign Exchange Risk and Benefits

What Happened
The exchange rate between the U.S. dollar and the Chinese yuan has been a matter of contention between the two governments for quite some time. Put simply, the U.S. accuses China of manipulating the currency exchange rate. Strictly speaking, that is exactly right as it must be for unilaterally fixed exchange rates. In practice, the USD/CNY currency rate trades at a rate higher where it would be in a free-floating market, making China's exports cheaper than they would otherwise be and making imports into China correspondingly more expensive.

The U.S. has tried many different ways to get China to adjust its position on the currency issue such as negotiations, threats and trying to line up allies in the fight. Most recently, the Senate passed a bill aimed squarely at the Chinese - though officially targeting any country with a "fundamentally misaligned currency" - that would empower the government to impose import tariffs on Chinese goods if the exchange rate is not changed.

Although the bill does not seem likely to get through the House or signed into law, the Chinese have not surprisingly responded with a fair bit of anger. Included in this has been the requisite warnings that such a move violates World Trade Organization rules and could prompt retaliation and ultimately a trade war.

That's not all. China added a bit of heft to its words this time. After the bill passed, the Chinese reset the exchange rate to the USD to 6.3598, an increase of 116 pips. A 0.116% move is not exactly a world-changer, but it does reverse the trend in the exchange rate. The meaning of the move is lost on no one. (Find out how a currency's relative value reflects a country's economic health and impacts your investment returns. For more, see 6 Factors That Influence Exchange Rates.)

What It Means
This is not a large move, and it is not going to dramatically alter any trade flows or business. Said differently, a one-day 0.2% move will not move the needle on the prices of goods at the local Walmart (NYSE:WMT). Moreover, the impact of this move is likely being magnified by the fact that the currency markets are nervous, risk-averse and news-starved right now. In such a market, any turbulence can get blown out of proportion quite quickly.

There is another meaning, though, and it's more significant. This move reemphasizes that China will not be jaw-boned or pushed around by the U.S. when it comes to matters of economic policy. Perhaps moreso than any other major economic power today, China is hyper-sensitive to any perceived slight or infringement on its national sovereignty. This is a byproduct of being pushed around by Western powers not all that long ago. While Japan tolerated the railings of U.S. politicians against its "unfair" trade practices with little public reaction, China's fuse is cut much shorter.

Along those lines, this currency move reminds investors that China can be a major destabilizing force in the global economy if and when it wants to do so. While U.S. and European political and financial heads try to triage the Greece situation, China stands by with the ammunition to cause yet another global credit crisis if it so chooses to do so (leaving aside that China has much to lose from it as well). (These indicators can illuminate the depth and severity of problems in the credit markets. For more, see 5 Signs Of A Credit Crisis.)

How It Will Impact U.S. Businesses and Investors
Assuming that China is simply making a political point and does not intend to force a new trend of yuan depreciation, the impact of this particular move will be minimal. It's a tiny change to almost anyone who isn't a highly-levered currency trader. With the G20 summit coming on in early November, it is likely that China will want to be seen as powerful but sensible. Thus far, the G20 has been reluctant to support the U.S. position on China's currency exchange rate, and China needs that to continue.

Longer term, there are certainly ramifications from this currency policy and a potential trade war. Those politicians advocating a new tariff on Chinese imports might want to look up "Smoot Hawley" and see how well that all worked out. Sparking a new recession just to win a few political points is not an economically sound strategy.

At the same time, it is worth remembering that China is not the sole source of the U.S.'s economic problems. China did not force U.S. banks to loan money to less credit worthy borrowers, it did not allow Medicare and Medicaid to become hydra-like monsters, and it did not force the U.S. to rack up huge debts and deficits to simultaneously fund wars and tax cuts.

Consumers and investors also need to realize that a compliant China has costs as well. A stronger Chinese currency will mean that Chinese imports are more expensive. That means more pain at the store. In theory, some of the manufacturing that was offshored to China will come back, but in practice it is more likely that it would just be moved on to a cheaper country like Vietnam with no net improvement in U.S. jobs. This would also result in more expensive goods for U.S. shoppers.

At the same time, this policy costs China as well. China has an inflation problem that is exacerbated by its artificial currency exchange rate. The exchange rate, and the position of the U.S. dollar as a global reserve currency, allows us to effectively export inflation. Likewise, China's currency policy is essentially a subsidy to its manufacturing sector and subsidies tend to have familiar consequences. The protected industries get fat, soft, lazy and cannot compete once the subsidy becomes economically nonviable. (For related reading on similar consequences, see Forces Behind Interest Rates.)

The Bottom Line
Trade wars are not nearly so bad as shooting wars, but they are serious nonetheless. Ultimately, the U.S. and China have to learn how to play together in the same sandbox. In the meantime, China is doing what every other country does – playing its strongest card. After all, the U.S. prints money to advance its politico-economic needs, the Japanese keep their interest rates incredibly low and the Russians periodically shut off the gas lines to Europe. Ultimately, China will find that the cost of an artificial exchange rate is too much to bear. In the meantime, U.S. investors should realize that apart from adding a little jolt to an already-shaky market, the real consequences are likely to be less than feared.

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