Recent Rumblings from China

December 10th, 2015 | By Nick Sargen

Risk of a Sino-U.S. Conflict

Normally, I confine my prognostications to assessing economies and markets, rather than geo-political developments. However, a recent Bank Credit Analyst (BCA)[1] report on the topic of potential conflict between China and the U.S. is worth sharing. The essence of BCA’s argument is that most investors believe the prospect for conflict is low, because both countries have too much to lose. However, the authors contend several developments have increased the risk of conflict. These developments include China’s desire to expand its regional clout, while the U.S. continues to pivot to Asia by expanding agreements such as the Trans-Pacific Partnership Treaty (TPP), and Japan is remilitarizing in the wake of disputes over territorial claims in the South China Sea. I do not claim to be an expert on these issues. However, one thing is clear – namely, China’s leader, Xi Jinping, is the most powerful since Deng Xiaoping and is more assertive in both foreign and domestic affairs than his predecessors.

In these circumstances, it is imperative that the U.S. government have a clear stance on what is vital to our interest and what is not, and I will highlight the need to get our stance on trade policy and exchange rate policy right. This issue first surfaced in the mid-1980s when Japan ran large bilateral trade surpluses with the U.S., and U.S. officials accused Japan of manipulating its exchange rate. From 1985 to 1994, the yen appreciated from Y265 to Y85, without achieving a significant change in the trade imbalance. Yet, Treasury Secretary Lloyd Bentsen was actively talking the dollar down, even as Japan was mired in a recession that contributed to deflation. In my view, the U.S. stance then was misguided and exacerbated the problems Japan faced after its bubble burst.

During the past decade, it appeared we might be headed for a similar conflict with China, as its current account surplus mushroomed after it had been granted status in the WTO. Faced with protectionist pressures in Congress, the Chinese authorities pursued a policy of allowing the yuan to appreciate steadily versus the dollar (by 35% over the past 10 years), while also accumulating massive FX reserves, most of which consisted of U.S. treasuries.

While China’s surplus has shrunk considerably in the meantime, markets became fixated on China’s exchange rate policy in August, when the yuan depreciated by 3% and officials announced that they would permit greater exchange rate flexibility in the future. Newspaper headlines reported it was the largest devaluation of China’s currency in two decades and that China’s action threatened to start a round of “currency wars.” It is an example of terrible reporting: Instead of enlightening readers that China is seeking to gain IMF acceptance of the renminbi (RMB) as a reserve currency, it created a false impression that China was manipulating its currency.

My bottom line is that U.S. policy should continue to encourage China to open its markets and allow market forces to play a greater role, which the Chinese authorities claim they are seeking. At the same time, I believe it is a mistake for U.S. officials to fixate on the level of the exchange rate or the size of the trade imbalance.


The Dollar’s Status as the World’s Leading Currency

This issue is much easier to assess. There simply is no viable alternative to the dollar in the foreseeable future.

The question of the dollar’s status surfaced 45 years ago, when the U.S. became a high inflation country and the Bretton Woods system of fixed exchange rates broke down. Policymakers have since learned the lesson of what happens when inflation is rampant, and the Fed has done a good job on the inflation front since the early 1980s.

Despite Japan’s massive surpluses, the yen never challenged the dollar in the 1980s and 1990s, because its capital markets are not as deep and open as the United States. And the same is true of China today. This leaves the euro as the only viable alternative to the dollar. However, the problems in the euro-zone leave its status in question.

The principal advantage to the U.S. is the ability to attract capital from abroad on favorable terms. One consequence, however, is that the value of the dollar is free to fluctuate broadly. While some have criticized the U.S. policy of “benign neglect” of the dollar, it is a natural response to being the world’s leading currency.

[1] Also known as BCA Research