No.1 in a Catch-22

Why should US care about Chinese currency valuation?

For any nation, it's critical that the exports and imports strike a balance for a healthy economy. The balance of trade is calculated as the monetary difference between exports and imports of a country. If exports are greater than imports, then the country is said to be running a trade surplus and the reverse, a trade deficit. Every country tries to be a surplus country. When you have a surplus economy, it means you produce more than you consume and eventually end up having a larger savings. For countries like US, where consumption is huge and the domestic products are generally costlier than imported Chinese products, economies always are prone to running in deficits.

Small trade deficits are generally not considered to be harmful to either the importing or exporting economy. However, large trade deficits for prolonged durations will mean debt for the nation and large amounts of foreign currency reserves(especially dollar) for the surplus countries(china). Some economists contend that the U.S. is borrowing to fund consumption of imports while accumulating unsustainable amounts of debt. Nonetheless, whether small or large, trade deficits generated in tradeable goods such as manufactured goods or software may impact domestic employment to different degrees than trade deficits in raw materials.

The recent recession changed the scenario of the market and the views of American policy-makers. America, which is used to squandering and excessive consumption of resources, wants to increase its exports to recover financially. It wants to decrease its import related debts and channeling of its funds into other economies. However, surplus-driven economies as China keep their currencies undervalued so as to maintain the demand for their products.
This is how it works: Suppose you manufacture a chocolate for 3 rupees. You plan to sell it for 5 rupees no matter to whom. Now, if there is a country X which has a currency μ and as per your economic statuses, 1 μ = 5 rupees. But, you insist, your currency rupee is of lower value and 1 μ = 10 rupees. So, as you already planned to sell the chocolate for 5 rupees, you sell it for 0.5 μ rather than the actual 1 μ making your product cheaply available compared to other manufacturers.
In a similar fashion, US argues that Chinese products enjoy an unfair demand depressing its domestic manufacturing industries.

China ran up a record $28 billion trade surplus with the U.S. in August, bolstering complaints from American business groups and lawmakers that a weak Chinese currency gives exports an unfair advantage. US imports in 2009 amounted to $1.558 trillion whereas exports amounted to $1.057 trillion. This deficit of half a trillion depicts the extreme levels of trade deficit. Of these, just the imports of medicines, household appliances, electronic gadgets, clothes, furniture and other automobile imports from China along with crude oil account for roughly $350 billion which clearly shows USA has a reason to worry about Yuan(Chinese currency) undervaluation.

US wants China to revalue its Yuan. What might be the effects of this move?

As some economists say, when Yuan is re-valued to a higher value, the prices of the Chinese products shall increase and therefore, the US manufacturers can compete with those of their Chinese counterparts and as a result, US can reduce some of the huge trade deficit. However, it's not necessarily true. While some manufacturers from some sectors may see the tremendous benefits, some others may see little and a few others might even feel it detrimental. US manufacturers, obtaining raw materials and intermediates from China at low rates, will have to then buy them at higher prices, which given the current situation of US is not really good.

Also, the current Chinese monetary policy helps keeping the interest rates low in US. Technically, as the current yuan is available at 8 yuan per 1 dollar, Chinese central bank must promise to be able to redeem 1 dollar for every 8 yuan to keep its currency fixed against the US dollar. So, as the Chinese economy grows and more and more yuan enters the market, Chinese central bank buys US treasury bonds increasing its dollar reserves and thereby allowing the US treasury department maintain lower interest rates than what they would have without the Chinese. So, in fact, Chinese are helping for the US citizens to avail themselves of cheap debt.

Now, if the yuan is strengthened as per the demands of US, it no longer needs to buy as many dollars as it does now causing a strain in the US economy. This might not only slow down the US economy but also push it into a recession as the interest rates would rise and so the consumers would stop spending so much money. Even if the US manufactured products can now compete with the Chinese ones, they no longer will be able to sell their products. It could push the already strained US economy into a downward spiral.

So, what do you propose to do? Nothing?

Not really. Eventually China should re-valuate its currency lest the global trade imbalances with China should grow too large. It's possible to do so in the long term so that both the economies can keep growing. It's also possible to do it in an entirely wrong way so that both the economies might spiral downward.

But, the real catch-22 here is the predicament US is in now, it brought it upon itself from careless squandering and extreme spending. They should learn to save a little if they want to get out of the current situation but saving more would mean spending little which in the current situation is not good at all for the US. Only time will tell how US is gonna handle the Chinese to remain in the No.1 seat.

Celebrating everything,

Aravind M
http://www.aravind90.blogspot.com