Want China to Float the Yuan? Careful What You Wish For

By Grey Owl Capital Management (Guest Contributor)

On Monday, a bipartisan group of 130 members of the U.S. House of Representatives sent a letter to Treasury Secretary Timothy Geithner and Commerce Secretary Gary Locke urging the agencies to use “all available resources” to end what they view as damaging currency manipulation by China. The full text of the letter can be found here.

The letter states “By pegging the renminbi (RMB) to the U.S. dollar at a fixed exchange rate, China unfairly subsidizes its exports and disadvantages foreign imports”. True, but who do they think is benefiting from the subsidy? The congressmen are overlooking the fact that by allowing Chinese manufacturers to sell goods for less it allows American consumers to BUY goods for lower prices. It is the U.S. consumer that is ultimately receiving the subsidy, not Chinese manufacturing companies. Be careful what you wish for: a higher RMB/USD exchange rate would lead to higher real costs for all U.S. consumers.

These Congressmen are playing up to concerned workers, while ignoring the fact that every single one of their constituents that purchases goods made in China benefits from this subsidy. The letter states that “China’s exchange-rate misalignment threatens the stability of the global financial system by contributing to rampant Chinese inflation and accumulation of foreign reserves.” Where do they think the inflation will go if not to China? It would stay here, is where. In 2009, the U.S. trade deficit with China was $226 billion. Personal consumption expenditures were a bit over $10 Trillion. So, the trade deficit with China was 2.2% of personal consumption. If the RMB were to appreciate by 20%, it would amount to an increase in costs of $45 Billion or .4% of personal consumption. This back-of-the-envelope calculation indicates that a 20% increase in the RMB would increase consumer price inflation by roughly .4%. Be careful what you wish for: a higher RMB/USD exchange rate would lead to higher inflation in the U.S.

The direct assertion of the letter is that if the U.S. places tariffs and regulations on China then the goods being manufactured there will be manufactured in the U.S. and put unemployed workers back to work. In reality the U.S. and China are not the only place where commerce can flow. In all likelihood, restricting the flow of goods from China will lead to those goods coming in from other lower cost countries like India, Mexico, or Malaysia. Are we then going to place tariffs and restrictions on imports from EVERY country in an effort to reduce unemployment? This might be popular with the press, but it would act like a large tax on consumers.

The final unintended consequence of pushing the Chinese to revalue their currency relates to the large “accumulation of foreign reserves” by the Chinese. China has used $889 Billion of their reserves to purchase U.S. Treasury obligations, making them the largest foreign holder of our debt. This is up from $739 Billion just one year ago. In the absence of China’s willingness to acquire our excessive debt, the United States would have to pay higher interest rates to attract other lenders. Be careful what you wish for: a higher RMB/USD exchange rate would lead to higher risk-free interest rates, which impacts rates for almost every borrower.

In summary, strong-arming China to revalue their currency, while perhaps politically popular, would have several adverse unintended consequences: higher real costs, higher inflation, and higher interest rates. We say, let the Chinese continue to peg the RMB to the U.S. dollar. On balance it is considerably more helpful than hurtful to the U.S. at China’s expense. Be careful what you wish for.

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