Exchange-Rate Politics: Playing with Fire

Democratic presidential candidates Hillary Clinton and Barack Obama have thrown their support behind proposed legislation that would impose anti-dumping duties—tariffs of around 27 percent—on Chinese imports if the Chinese currency doesn’t get stronger against the dollar. This proposal—advanced by a bipartisan coalition of protectionists—is shameful, reckless, and dangerous. (Other than that, it’s just fine.)

The protectionists are trying to reduce the U.S. trade deficit by manipulating a change in the exchange rate with the renminbi (yuan). By demanding that the Chinese monetary authorities engineer an appreciation of the renminbi, the senators are essentially calling for a depreciation (a weakening of the purchasing power) of the dollar.

There are multiple objections to this maneuver. First of all, the Chinese own over a trillion dollars of American debt. This is money that we owe to them. However, if the renminbi appreciates by ten percent against the dollar, the result is a de facto devaluation of the dollar, and—presto!—the purchasing power of our creditors has shrunk by ten percent. The Chinese would absorb a huge loss. Essentially, then, the senators are threatening to punish the Chinese with new tariffs if the Chinese don’t manipulate the foreign exchange market in a way that will cost them tens of billions in purchasing power. How would we feel if the Chinese, or anybody else, pressured us to take such a hit? Right now, holders of Ecuadorean bonds are holding their breath to see if the Ecuadorean government will honor those debt obligations at face value. And here we are—the wealthiest country in the world—behaving like some banana republic, trying to avoid honoring our debt obligations.

Apart from the unseemly extortionist flavor of the senators’ proposal, a second objection is the economic fact that there is no mechanistic relationship between exchange rates and trade deficits. In other words, the renminbi could appreciate significantly against the dollar, and yet the senators’ stated goal of reducing the trade deficit might not follow. As an example, the U.S. trade deficit with Japan has stubbornly persisted, even while the yen strengthened from an exchange rate of over 300 per dollar to under 100 per dollar (approximately 122 per dollar today). Similarly, the dollar has weakened against most currencies over the last five years, even while the overall American trade deficit has continued to rise. The fact of the matter is that the renminbi could double, making what used to be a daily Chinese wage rate of two dollars double to the equivalent of four dollars, yet (depending on worker productivity) the Chinese could still enjoy an unbeatable cost advantage.

A third objection to the senators’ proposal is the presumption that a weaker dollar is somehow desirable. While exporters may enjoy increased sales if the dollar weakens, the overall purchasing power of dollar-holders declines. Just ask anyone who has traveled to Europe or Canada lately how much they like the weaker dollar. A strong country traditionally has a strong currency—one with considerable buying power. One hallmark of the “banana republics” referred to above is a weak currency. Why are our senators so eager to bring us to banana republic status?

A fourth objection to this short-sighted policy proposal is the risk of a financial accident. Chinese monetary policy has been governed by prudence and practicality. There was nothing sinister when the Chinese monetary authorities “pegged” their currency to the dollar from 1994 to 2005. Floating exchange rates add a lot of uncertainty and financial risk to international commerce, whereas stable exchange rates benefit businesses on both sides of a currency exchange. Since the U.S. dollar was the world’s reserve currency and the U.S. would be one of China’s primary trading partners, it made sense for the Chinese to stabilize the dollar-renminbi exchange rate.

Now the Chinese are permitting the renminbi to appreciate against the dollar gradually, but not fast enough to suit the protectionist senators. Again, the Chinese policy is prudent. China’s financial institutions are not as mature as our own, and might not be able to adjust to rapidly changing exchange rates without triggering a financial crisis. Look, the Chinese can be reckless. They own two percent of the world’s automobiles, but have seventeen percent of the world’s car accidents. They are clearly in a hurry to become wealthy, and it is possible that the wheels may fly off the speeding car which is the Chinese economy. If that should happen after a Chinese monetary revaluation implemented under pressure from the United States, we would be made the scapegoats for their mess. Why put ourselves in that position and invite hatred? And don’t think that our own economy wouldn’t be at risk. Since China holds so many dollars, a financial crisis there could easily spread to the United States.

The timing of this legislative proposal could hardly be worse. Right now, the dollar is perched precariously at a multi-year technical support level. If the dollar weakens from its current position in the global currency markets, its value could plunge. This, in turn, would likely precipitate a sell-off in bonds and a corresponding rise in interest rates—hardly what Americans want now. It would be interesting, though, to see how the protectionist senators would explain themselves if their strong-arm tactics didn’t shrink the trade deficit, but instead managed to shrink the assets of the American people; however, I think it would be better for us all if it doesn’t come to that.