Monday, March 22, 2010

China’s got options

This morning there was an abundance of links evidencing the building anxiety over U.S.-China relations. Edward Harrison at Credit Writedowns links to a Reuters article, China vows to hit back if targeted by U.S. on yuan. Calculated Risk refers to commentary at the Financial Times and the Washington Post referencing China Losing Support of American Business Community.

Let's think about the currency from a U.S. auto exporter's viewpoint. The China Daily looks at China's relatively “young” automotive market compared to its developed U.S. counterpart. But what if the yuan appreciates more than expected against the U.S. dollar? This market would develop much quicker than the article portends, and the room for revenue growth is vast.

Deutsche Welle also reports the benefits that Europe would incur from a stronger yuan compared to the U.S. dollar, which gives me pause: why exactly would Europe profit from an appreciation of the Chinese yuan against the U.S. dollar? The U.S. export industry, yes, but Europe? Deutsche Welle tells us:
"But Europe stands to benefit a lot, because with a revaluation, European products would become more affordable for Chinese consumers and companies alike and we would definitely feel the benefits in terms of better exports," said Schularick.
This is an entirely one-sided argument: if the Chinese yuan appreciates, then export income would be diverted away from Chinese exports and toward Chinese imports, paving the way for Europe to reap the benefits. Same story as in the U.S. auto maker case, but with a twist: China has options.

First, China drops the currency peg, allowing its exchange rate to float (appreciate) against the U.S. dollar (USD). In this situation, the USD will depreciate not only against the Chinese yuan (CNY), but more likely against all currencies to which the USD is implicitly pegged via the yuan.

It’s pretty simple, really, if you think about cross rates: USD:CNY / EUR:CNY = USD:EUR. If USD:CNY falls (i.e., the U.S. dollar depreciates against the Chinese yuan), and that depreciation is not matched by an equal increase of the EUR:CNY (appreciation of the Eurozone euro against the Chinese yuan), then you get a depreciation of the U.S. dollar against the euro (the USD:EUR falls).

Point 1: as the Chinese yuan floats, it’s very likely that all else equal, the U.S. dollar depreciates against the euro. This improves the near-term prospects for U.S. exports to Europe, and reduces those for European exports to the U.S. (given sticky prices). Therefore, the increased demand for European exports to China will be offset somewhat by the decline in demand for those to the U.S.

Second, given that the Chinese do not allow the yuan to float (much more likely), who’s to say that the Chinese will not simply substitute one peg for another, i.e., target the euro to a larger degree? This would be very simple; and frankly, a euro peg would make more sense, given the trade flows between Europe and China.

Europe is a natural market for Chinese exports: in 2007, 24% of China’s exports landed in Europe, while 21% shipped to North America. All else equal, a euro peg would be quite an effective “export growth tool” if the Chinese shifted their asset base from U.S.-denominated assets toward Euro-denominated assets.

Point to 2: Europe would be very much worse off if China simply increased the weight of the euro in its currency target basket. The biggest economy in the Eurozone, Germany, is an “exporter” itself. Talk about trade wars!

U.S.-China bi-lateral relations SHOULD BE TREATED as a multi-lateral story; they're interconnected.

Rebecca Wilder
Rebecca Wilder


  1. no disagreement, but it looks like it wont happen anytime soon: 

    from the Economist:
    <span>China, importer</span> - TWO weeks ago, China <span><span>released</span></span> trade data for the month of February. Where monthly trade surpluses during the pre-crisis boom years had been in the $20 billion to $30 billion range, China recorded a $14 billion surplus in January, and just an $8 billion surplus in the month of February—results, China's government used to argue that currency adjustment isn't necessary. Now, we learn <span><span>this</span></span>: The country will probably see a "record trade deficit" in March thanks to surging imports, Minister of Commerce Chen Deming said on Sunday, while warning that Beijing will "fight back" if Washington labels China a currency manipulator. That would certainly complicate the arguments of those demanding a revaluation. Amid heated rhetoric on the issue, the stakes have been steadily <span><span>climbing</span></span>...

  2. A point of argument many are missing is the power of acquisition by the Chinese. As it stands, China is now buying more of Arabia's oil than the US, and worldwide, if the yuan appreciates, then China's ability to snap-up assets increases too.

  3. Stephen, oil's sold in $US dollars! They have plenty of FX reserves with which they can buy for some time no matter how they value the yuan. And let them go and buy product from Nigeria, Angola, or Saudi Arabia. We have Nafta (i.e., free trade with Canada) and many proven reserves sitting off our coasts. Rebecca

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  5. <span>Naked Capitalism's take on this point, which leads us to Marshall Auerback's longer-standing call on RMB DEPRECIATION. It's complicated!