U.S. Calls China a “Currency Manipulator”

Don’t you just love it when politicians put their foots in their mouths and say things, stupid things? Especially words spoken (or in this case written) that have huge repercussions for their countries? On the other hand, some people believe such snafus might even be planned and staged, for a more sinister purpose. In the following case, I’ll leave the decision up to you.

In a written response to questions from senators debating his confirmation, Mr Geithner accused China of “manipulating” its currency and promised that the Obama team would push “aggressively” for Beijing to change its policies. The sharp tone and use of the legally-loaded term “currency manipulation” ricocheted through financial markets as investors shuddered at the prospect of a Sino-American spat in the midst of a global slump.

Tim Geithner

Clearly this was not a slip of the tongue. It might, conceivably, even have been a bureaucratic snafu. The tough language came in a 102-page document answering numerous questions from senators — an odd place from which to lob a bombshell at Beijing. If so, it speaks poorly of a man who is already in trouble for failing to pay attention to his taxes. Most likely, therefore, Mr Geithner’s language suggests a change in Washington’s tactics towards China.

American policymakers have long pushed Beijing to accelerate the appreciation of the yuan, arguing that China’s exchange-rate policy played a big role in creating the global imbalances and that—both for the sake of China’s economy and the rest of the world—the currency needs to strengthen. However, Hank Paulson’s Treasury studiously avoided accusing Beijing of “currency manipulation”, a term that carries legal implications.

Every six months, the U.S. Treasury must publish a list of countries which it deems to be currency manipulators. Once a country appears on that list, formal negotiations to end the manipulation must begin. The Treasury under George Bush, particularly in recent years, preferred a softer behind-the-scenes approach and refused to brand China a manipulator. Although Mr Geithner did not commit himself to any specific action, the use of the m-word suggests Team Obama will take a tougher line.

Exactly what it means is uncertain. It is not even clear who will manage America’s economic strategy with China (there is some speculation, for instance, that Hillary Clinton wants the State Department to take the lead). But there is no doubt that Barack Obama’s economic team includes a number of people who are frustrated with the world’s failure to convince Beijing to strengthen the yuan. Mr Obama himself supported legislation in the Senate to get tougher on China. More important, his advisers see tough words now as a prophylactic—a warning that Beijing must not be tempted to prop up its staggering economy by weakening the yuan.

Domestic politics also plays a big role. China’s bilateral trade surplus with America has long been a lightning rod in Congress, and with unemployment up the protectionist pressure is sure to rise. The $800 billion stimulus package making its way through Congress already has dubious “Buy American” measures that demand government spending should be on American goods. By sounding tough up front, the logic goes, the Obama team will be better able to diffuse the more extreme protectionist sentiment.

Unfortunately, this strategy is dangerous on a number of counts. The basic economic analysis—that a stronger yuan, on a trade-weighted basis, is necessary to rebalance China’s economy away from exports—is surely right. But the world’s immediate problem is a dramatic shortfall in demand across the globe and that will not be righted by exchange-rate shifts. Currency movements switch demand between countries; they do not create it. In the short-term, therefore, the outlook for the world economy depends on whether governments’ stimulus packages are successful and, right now, team Obama would do better to focus on the scale, nature and speed of Beijing’s stimulus measures than rant about the currency. What’s more, the evidence for currency manipulation is weakening. Although China still runs a huge current-account surplus, it is no longer accumulating foreign-exchange reserves at a rapid clip, as capital is flowing out of the country.

Like all politicians, he qualified his statement with various good wishes toward the Chinese, but the damage was quickly done. Markets began to wonder if China would retaliate by scaling back its massive purchases of U.S. government debt, contributing to a 70-basis-point sell-off in 10-year U.S. Treasury bonds between Jan. 26 and Feb. 4.

More important, the political calculus could easily misfire. Domestically, Mr Geithner’s comments may simply fan congressional flames for tougher action on China. Lindsey Graham, a senator who first pushed for a 27.5% tariff against China in 2005, called the comments “music to my ears”. And Sino-American economic tensions are already rising as Chinese officials hotly dispute the idea that their savings surplus had anything to do with the current global mess. (An official at China’s central bank recently called the idea “ridiculous” and an example of “gangster logic”). Traditionally, Chinese officials do not respond well to public admonition and, given the scale of China’s economic woes, they are likely to be pricklier now.

The stakes are extremely high. Everyone knows that protectionism and beggar-thy-neighbour policies exacerbated the Depression. With the global economy in its most dangerous circumstances since the 1930s, rising Sino-American tensions is the last thing anyone needs.

There’s even more bad news. Geithner’s utterance caused interest rates to jump, costing prospective American homeowners (and many that were seeking to refinance existing mortgages) around 10% more in interest charges. Making home loans more expensive is not a great way to get the housing market moving — nor is it a great way to instill confidence in debt markets. The sell-off quelled a major rally in Treasuries as investors who had been flocking to the safe haven of government paper amid the global recession questioned whether Treasuries had become too expensive. In the last four months of 2008, yields (which decline as prices rise) dropped from 4% to a low of 2.25%.

But the rally isn’t over. The fear that China will stop buying U.S. debt is unfounded. Beijing can’t buy anything else with its excess dollars. There are simply no alternative investments that are large enough or liquid enough. But more importantly, there are fundamental reasons why Treasury prices will move much higher (and yields lower) — and why the current opportunity to go long U.S. Treasuries should be grasped with both hands.

There are two aspects of the ongoing recession that may come as a surprise to some observers as events unfold. The first will be the failure of central banks to re-ignite credit growth in the ailing banking system. The second will be the failure of governments’ debt expansions to increase the cost of funding. In other words, the long end of the yield curve will continue to be depressed, just as it has been in Japan for the past 16 years. In the early 1990s observers in Japan argued that 10-year Japan government-bond yields of 3.5% could not persist for long. That was when the government debt-to-GDP ratio was around 50%. It now stands at 150% and 10-year yields are 1.36% (having gone as low as 60 basis points in the interim).

In our view, yields on U.S. 10-year Treasury notes will fall to between 1.5% and 2% by the end of 2009. This is because the banks are broken and their customers are keen to spend less. The monetary base, the money element that the Fed can control, is a fraction of credit outstanding in the U.S. system ($2 trillion versus $47 trillion). No matter how fast base money is pumped up, the reduction in credit outstanding will overwhelm it. During this phase we should expect credit contraction and its attendant deflationary effects on asset prices and consumer goods and services.

Yields are also bound to go lower because demand for U.S. government debt will easily match supply, even though Washington must sell hundreds of billions of dollars in bonds in coming months to fund stimulus measures and bank rescues. Consider the uncanny parallel between the composition of assets on bank balance sheets in 1929 and balance sheets at the start of this crisis. The ratio of loans to investments, which include Treasuries and other securities, was 2.6:1 in 1929 and 2.8:1 in 2008. During the early period of the Great Depression, banks restructured their balance sheets to reflect a much more conservative lending stance. They reduced loans — in absolute and relative terms — and increased investments in safe assets, mostly Treasuries.

Of course, there are major differences between today’s banking and monetary systems and those of the 1930s, but the one constant is human behavior. Personal balance sheets, corporate balance sheets and bank balance sheets will inexorably move into safer instruments given the wealth destruction that has occurred in riskier assets over the past year (and which will continue for the foreseeable future). If the banking sector alone were to move toward its more conservative 1935 ratios, then the increased demand for government paper from that source alone would be $700 billion.

It’s likely that shifts in household and corporate investment patterns will produce even greater demand — which is why U.S. 10-year notes remain attractive, not for their paltry yield but for their capital-gain potential. The next bull market will be concentrated in government paper — even as confidence in government itself erodes.

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