China and the U.S. Play Chicken: Currency Manipulation
"China is manipulating its currency," proclaims incoming Treasury Secretary Geithner. Talking about "manipulation" is helpful only if one's intent is to impress a local and insult a foreign audience. More productive may be plain talk - the U.S. and China could issue a joint statement along the lines of: "China and the U.S. agree that both will act in their respective self-interest in setting exchange rate policy."
Many factors including supply and demand for a currency ultimately determine exchange rates. The U.S. is doing its share to try to manipulate the dollar, albeit with mixed results. Amongst others, last summer, the Treasury decided to make the guarantee for the housing agencies Fannie and Freddie more explicit. With the Chinese and other foreigners being the main buyers of U.S. debt in recent years, there was a threat that these buyers would abstain. Foreign investment in the U.S. had fallen off a cliff in the second quarter of 2008; the absence of foreign buying could have caused a panic in the dollar. By providing the guarantees, the U.S. seemed the least risky country for short-term money, giving a boost to the dollar. Note, however, that the inflows were mostly parked in short-term Treasuries, not exactly an endorsement of the U.S. economy, but more likely a panic trade that may be unwound again.
While last summer's action was aimed at avoiding a disorderly collapse of the dollar, policy makers have made it abundantly clear that they want a weaker dollar. The ritual that Geithner followed to state that a strong dollar is in the interest of the U.S. has become a farce. Suggesting China should allow its currency to appreciate is certainly not compatible with it. Neither are Federal Reserve (Fed) Chairman's repeated references that weakening the currency by going off the gold standard helped the U.S. out of the Great Depression by "allowing prices to float to the pre 1929 levels." In our assessment, the Fed is encouraging inflation, so that the relative prices of homes to all other goods and services will come down. That may be the Fed's "plan B" as it doesn't want absolute home prices to come down any further; a weaker dollar contributes to achieving this. We have cautioned in the past that a country cannot depreciate itself into prosperity, but that won't stop policy makers from trying. Pulling interest rates to near zero is also a form of currency manipulation, trying to make the currency less attractive.
While former Fed Chairman Greenspan always avoided discussing the dollar, the current Fed Chairman embraces the confrontation, not just by seeking the discussion, but also through action. Beyond lowering interest rates, the Fed is trying to weaken the dollar with its purchases of agency securities and government bonds. With their government guarantees, Fannie and Freddie are buying billions worth of mortgage securities to lower the cost of borrowing to consumers; the agencies have also lowered their traditionally high standards on who qualifies for subsidized loans. Already Freddie Mac has asked Uncle Sam for another $35 billion as it is throwing taxpayer money at consumers. The activities pursued are in the realm of currency manipulation as the types of securities foreigners would typically want to buy are inflated in price, discouraging the purchases.
Indeed, any market where the Federal Reserve has engaged in purchases - agency securities, mortgage backed securities, providing funding for consumer loans, the commercial paper market, to name a few - the Fed is replacing rational buyers rather than jumpstarting the private sector. Why would a rational person buy securities that are artificially inflated in price? If the Chinese dare to buy these securities anyway, then they must be as guilty as the U.S. of currency manipulation.
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Indeed, that's what it comes down to: the U.S. wants to have a weaker dollar and China wants to be in control of when to allow the yuan to appreciate. Insulting China is not the right way to go about it. China has to recognize that a stronger yuan is in its national interest. While the U.S. is accelerating its market interventions with implications for the dollar, China is working hard to allow for more exchange rate flexibility.
In our view, China cannot grow itself out of the current global economic downturn with a cheap currency. U.S. consumer spending simply may not pick up fast enough because U.S. policies are aimed at propping up the broken system in place with high levels of consumer debt rather than fostering sustainable growth that includes savings and investments. Paradoxically, while the Chinese yuan may be cheap, overall policies continue to be relatively tight. China is aware that it has its own inflated property prices and is willing to allow price declines and failures of real estate developers. China has also not exhausted its potential to provide a stimulus to the economy: infrastructure projects in the pipeline in years to come could be moved forward far more aggressively. We would favor a major campaign to encourage domestic entrepreneurialism to jump-start a more balanced economy not as focused on exports. Part of the reason for the reluctance on China's part is because of inflationary fears. While everyone talks about deflation right now, inflationary pressures as the world recovers and as a result of the spending programs could be contained if China allowed the yuan to appreciate.
When China recognizes that it is in its interest to have a stronger yuan, China will act. In the meantime, the U.S. and China are playing a game of chicken. However, it is unclear what winning means in this context. The U.S. seems somehow excited to weaken its currency, depriving hundreds of millions of the purchasing power of their savings. Conversely, China's reluctance leads to more problems than it solves for China. China won't be bullied by the U.S.; however, a little more diplomacy and a little less populism may be beneficial to both China and the global economy.
We manage the Merk Hard and Asian Currency Funds, no-load mutual funds seeking to protect against a decline in the dollar by investing in baskets of hard and Asian currencies, respectively. To learn more about the Funds, or to subscribe to our free newsletter, please visit www.merkfund.com.