Why the U.S.-China Currency Brawl Puts Global Recovery at Risk


The bitter debate about health care reform may have taken center stage in the U.S., but it's hardly the only set of fireworks warranting investors' attention. A potentially more vicious international currency showdown is also materializing as some high-profile American lawmakers and economists attempt to force China to raise the value of the yuan. Their proposed weapon: threats of trade sanctions.

As a mid-April deadline approaches for the U.S. Treasury Department to consider whether to label China as a currency manipulator, some investors are watching the face-off with horror. Those investors rightly say that the last the thing the fledgling global recovery needs is a trade war between the world's largest economies.

Indeed, investors need to keep a close eye on this game of chicken -- in which the Americans applying the pressure are betting that their Chinese counterparts will blink. However, a miscalculation could lead to a destructive situation rivaling the Great Depression.

Some influential analysts, like Princeton University economist and Nobel laureate Paul Krugman, argue that the Chinese move -- at the onset of the financial crisis -- to peg the value of its currency at an exchange rate of 6.83 yuan to the U.S. dollar is dampening global growth. Moreover, they argue that by artificially depressing its currency, China is making its exports more competitive on the world stage and, in essence, stealing much-needed jobs from other countries.

Hot Debate About Cold Cash

As a remedy for China's mischief, the U.S. should slap a tariff of up to 25% on Chinese goods, Krugman and his cohorts have stridently advocated. And while many fret about the nearly $1 trillion in U.S. assets that China has amassed, tariff supporters argue that China wouldn't dump those assets and hurt the value of the dollar because such a move would also inflict injury on its own holdings.

That highhanded argument has caused an unusually violent outpouring for a debate about currencies. "We should take out the baseball bat on Paul Krugman," Morgan Stanley Asia head Stephen Roach said last week, according to Bloomberg News. "I mean, I think that the advice is completely wrong."

Over-the-top rhetoric aside, Roach has taken the right position. Not only does an escalation with China add unfathomable risks to already jittery markets but the condescending American push to dictate domestic Chinese affairs will be only counterproductive. The sharp, additional 25% cost increase that American importers of Chinese goods would likely pass on to U.S. consumers will only further damage those already battered shoppers.

In addition, China's central bank has already been telegraphing that a rise in the rate of the yuan is in the cards. With double-digit GDP growth and authorities scrambling to stem inflation, a stronger yuan would help slow the Chinese economy and boost much-needed domestic consumption.

Chinese Credibility at Stake

But the Chinese are no more likely to let their currency appreciate because the U.S. said to do so than President Obama is to cancel a meeting with the Dali Lama because of Chinese mandates, as China experts have pointed out. Indeed, following American orders would only damage the Chinese government's domestic credibility and make Beijing more reluctant to pursue U.S.-favored policies even when they're ultimately in its own interest.

Moreover, clamping down on the value of the yuan was a temporary measure China took in the wake of a financial crisis that, after all, stemmed from irresponsible speculation and lax regulation in the U.S. The Chinese had let the yuan rise 22% between 2005 and 2008, then had little choice but to hit the brakes when the crisis hit, some investors have pointed out.

"From [the Chinese] standpoint, what else were they to do?" John Mauldin of Millennium Wave Advisors wrote recently. "Force their country into a recession to appease our politicians?"

Now as the global economy shows signs of normalizing, all parties would be better off shelving the sharp words and blunt instruments. China is more likely to let the yuan gradually appreciate out of self-interest than because of intimidation.

Investors, though, should expect a sharp slide if the chest-thumping were to spiral out of control -- and turn into real action.