What's In a Name: Can the U.S. Afford to Call China a Currency Manipulator?

It seems like every six months the debate over China's currency, the yuan, reaches a fevered pitch: The Washington bureaucrats threaten to label China a "currency manipulator" and Beijing threatens to dump its U.S. debt holdings.

Then, with the imminent approach of a major inflection point – be it a key international summit or major financial report – both sides grudgingly agree that a modest appreciation of the yuan would be mutually beneficial.

However, things could be slightly different this time around. China has routinely ducked calls to revalue its currency, and in doing so greatly agitated the West.

Most recently, China removed the yuan's peg to the dollar, ceding to months of U.S. and global pressure on the issue just ahead of the Group 20 summit in June. However, U.S. policymakers were again left feeling had as the currency has gained just 1.5% against the dollar since that announcement.

That pace is far too sluggish for U.S. lawmakers who are counting on U.S. exports to help pull the country out of its economic malaise and have grown increasingly impatient with Beijing's unwillingness to compromise.

"China does basically whatever it wants while we grow weaker and they grow stronger. We clearly need concrete action here," said U.S. Sen. Christopher Dodd, D-CT. "This administration must be the one who takes a stand. For years the Treasury Department has relied on a strategy of dialogue which has yielded few meaningful reforms."

U.S. Treasury Secretary Timothy F. Geithner responded yesterday (Thursday) by taking his boldest steps yet in denouncing China's uneven currency practices.  The rhetoric comes three months after China pledged to revalue its currency, the yuan, and one month before the Treasury Secretary will deliver a currency report that could officially label China as a currency manipulator.

In testimony before the House Ways and Means Committee, Geithner said China uses "heavy intervention" to keep the yuan undervalued – a practice that has created a "major distortion" in the global economy that is having a "negative impact" on the United States especially.

The United States asserts that China deliberately keeps its currency undervalued to boost exports by making them cheaper for overseas buyers. Other countries – which include European nations as well as emerging markets like Brazil and India – have lobbed similar accusations.

"The pace of appreciation has been too slow and the extent of appreciation too limited," said Geithner. "We are examining the important question of what mix of tools, those available to the United States and multilateral approaches, might help encourage the Chinese authorities to move more quickly."

Geithner said the Treasury would take China's recent actions into account as it prepares its crucial Foreign Exchange Report. The Treasury's biannual foreign exchange report is due in Congress next month. In that report, the Treasury will again be forced into a decision over whether or not it should officially label China a "currency manipulator." Such a label would open the door to tariffs on Chinese imports.

Geithner has stopped short of affixing the currency manipulator label to China in his past three reports. He even pushed the release of its last report from April to June of this year to give China an opportunity to respond. However, time is running out for both parties to come to terms on the currency debate.

"With the bilateral trade imbalance widening and U.S. unemployment still very high, there is a rising danger that China could misjudge the amount of movement needed to placate the U.S.," Mark Williams of Capital Economics in London, told the Wall Street Journal. "Political developments can easily take on a momentum of their own."

More than 140 House members have signed onto a bill sponsored by U.S. Reps. Tim Ryan, D-OH, and Tim Murphy, R-PA, that would impose countervailing duties against China.

The United States on Wednesday brought two new cases to the World Trade Organization (WTO), accusing China of blocking imports of a specialty steel product and denying U.S. credit card companies access to its markets. The first case accused China of imposing duties of as much as 65% on U.S. flat-rolled electrical steel. The second dealt with China Union Pay, which since 2001 has had a monopoly on yuan-denominated debit and credit card payments in China.

U.S. Senator and chairman of the Senate Finance Committee Max Baucus, D-MT, applauded the filings, calling them "critical steps forward in our effort to enforce our market access rights in China."

"It's about time the administration decided to act," said U.S. Sen. Charles Grassley, R-IA. "The administration should go one step further and bring a case against China's unfair currency manipulation at the WTO."

Calls for a tougher stance on China will only heat up as the United States approaches mid-term elections in November.

"As the U.S. mid-term election nears, the temptation of grandstanding on China will be irresistible to most congressmen," Eswar Prasad, Cornell University economist and the former head of the International Monetary Fund's China department, told the Wall Street Journal. "Democrats and Republicans are trying to outdo each other in blustering about China's currency and trade policies."

Consequences of a Currency Conflict

Labeling China a currency manipulator or engaging the Red Dragon in an all out trade war will have consequences, but analysts are divided over what those consequences would be.

When pressed on the currency issue, Beijing traditionally has threatened to stop financing U.S. debt. China is the world's largest holder of U.S. Treasuries, with holdings of $846.7 billion in July.

Lou Jiwei, chairman of China's $300 billion sovereign wealth fund earlier this month said China should diversify its assets away from the dollar if the United States maintains loose monetary policy that weakens the currency.

"For China, the chief tools to reduce economic risks are to strengthen regulation of capital flows, control liquidity through cash management, monitor asset markets and divert foreign exchange reserves to non-dollar assets," Lou said.

Ding Yifan, a policy guru at the Development Research Centre, said China could force a rise in U.S. interest rates by unloading its holdings of U.S. debt, estimated at over $1.5 trillion. His comments at a forum in Beijing followed a string of remarks by Chinese officials questioning US credit-worthiness and the reliability of the dollar.

However, such threats have hardly left some economists quaking. 

"They are utterly wrong," Gabriel Stein from Lombard Street Research told The Guardian. "The lesson of the 1930s is that surplus countries with structurally weak domestic demand come off worst in a trade war."

Stein described the implicit threat to sell Treasuries as "empty bluster" because Beijing's purchase of these bonds is a side effect of its yuan policy.

"Bring it on: it will weaken the dollar, which is what the U.S. wants. The interest rate effect can be countered by the Fed," he said. "Some Chinese officials seem to believe that buying Treasuries underpins U.S. public spending. In fact China's mercantilist policy is forcing the U.S. to run large deficits against its own interest. China should be terrified of a trade war."

Stein is joined in that line of thinking by Nobel Prize winning economist Paul Krugman. Krugman said last week in the New York Times that "in a world awash with excess savings, we don't need China's money – especially because the Federal Reserve could and should buy up any bonds the Chinese sell."

"It's true that the dollar would fall if China decided to dump some American holdings," he said. "But this would actually help the U.S. economy, making our exports more competitive. Ask the Japanese, who want China to stop buying their bonds because those purchases are driving up the yen."

Japan on Wednesday intervened in the currency market for the first time since 2004 to weaken its currency, the yen, after China purchased Japanese bonds. Some analysts and Japanese policymakers had theorized that China was attempting to hamper Japan 's recovery by keeping the yen excessively strong.

"I don't know the true intention" behind China's purchase of $6.9 billion (583.1 billion yen) of Japanese government bonds in July, Finance Minister Yoshihiko Noda said earlier this month.

Interestingly, Japan, the second largest holder of Treasuries, was the biggest net buyer in July, boosting its portfolio by $17.4 billion to $821 billion. The gap between China and Japan has narrowed sharply this year, to just $25.7 billion from $129.1 billion at the end of 2009.

Japan, which was the largest foreign owner of Treasuries until September 2008, could once again overtake China if it continues to intervene to hold down the value of the yen.

"It would not be a total surprise to see Japan as the No.1 holder of Treasuries by the winter," Dan Greenhaus, chief economic strategist at Miller Tabak & Co., told The Journal.

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