Currencies | Jul 28 2009
By Greg Peel
President Obama has rebooted the US-China Strategic and Economic Dialogue (SED) with a broader agenda. Talks between the tiring superpower and the superpower-to-be commenced last night and will conclude tonight. After initial pleasantries, the groups split into two to knuckle down to some serious haggling. In one room were Secretary of State Clinton and her counterpart and in the other were Treasury Secretary Giethner and Vice Premier Wang Qishan.
While Ms Clinton will busy herself with matters of political strategy and climate issues, Geithner, as representative of the failed US investment banking system, will be humbled in discussing economic policy. It is in Geithner’s talks we are most interested.
Standard Chartered notes the China trade surplus with the US appears to have now peaked. The surplus blew out substantially in the boom as China’s cheap export goods were lapped up by debt-pumped Americans within the friendly bounds of a fixed-range exchange rate. Had the renminbi-dollar exchange rate been set free to find its own level, import prices would have risen for Americans, and thus demand and the resultant trade imbalance would not have been so extreme.
While happily snapping up Lucky Dragon fridges on the one hand, Americans spent the latter part of the boom railing against this artificial imbalance and the US manufacturing jobs lost to cheap labour in China on the other. Members of Obama’s more working class oriented party were particularly vocal in calling for protection for US industry against cheap Chinese imports. But now that the GFC has struck, protectionism is a dirty word given its historic path to Depression.
So Geithner’s task is to quietly encourage a greater pace in Chinese moves to quietly rebalance. China, too, fears excessive imbalance, as it threatens an implosion that would seriously derail the Chinese Miracle. But nor does China want to kill off economic growth by its own hand, so all rebalancing efforts to date have been subtle and slow.
The GFC has clearly relieved the immediate problem. US consumer demand has collapsed and so China’s export industry has collapsed. The trade imbalance has subsequently begun to correct and China has even been forced to depreciate its currency against the dollar after several years of quiet appreciation.
But it is not a rebalancing which is favouring either side. China’s exports to the US are down 15% but so are its imports from the US. Rebalancing would imply a reversal of flow rather than just a shut-up shop. The US consumer has put away his wallet but the Chinese consumer has not taken up the slack. Chinese domestic economic stimulus still has to see a flow-through to the man on the street. On that basis, Geithner will be pleading with China, Standard Chartered assumes, for it to continue rebalancing efforts while it can rather than waiting in the hope of a fresh improvement in exports.
Rebalancing is not just about the two currencies themselves. There are other factors underlying what the exchange rate represents. The exchange rate had appreciated 20% from 2005 until the GFC hit in earnest, but now it has slipped again. Economists suggest another 20% appreciation is needed. One way to encourage a more realistic balance is for China to further reform its interest rate system.
While China’s post-GFC stimulus policy has been to make credit to business as feely available as possible, there is a huge disparity between the borrowing rate and the deposit rate. Standard Charted suggests deposit rates are set too low as a de facto tax on people saving rather than spending and borrowing rates are set too high in some cases in order to keep control over credit growth. China has recognised a need to reign in this imbalance of its own and allow the market more control over rate levels. But moves to loosen the ties would result in inefficient banks hitting the wall. That rate gap makes up 80% of some banks’ profits and clearly only more efficient banks will survive a big cut to the spread. Can Beijing afford such a policy?
Beijing also has the People’s Bank of China to argue with, and its long been an opponent of rate reform.
Another path to rebalancing is to further encourage the growth of China’s corporate bond market. The theory is that allowing companies access to private funding would reduce their reliance on retained earnings, thus encouraging money velocity and greater economic growth. Geithner may have to tread lightly on pushing this particular angle however. All any Chinese delegate has to say is “So how’s your bond market faired these past couple of years?”
The subject of the International Monetary Fund will likely also arise as well, Standard Chartered speculates. The US had organised world governments into increasing IMF funding even before Geithner took over, and fear of more implosions like Iceland and Ireland emanating from Eastern Europe or elsewhere was enough for the entreaty not to fall on deaf ears. China pledged US50bn, which it intended to invest into the new IMF special drawing right bonds. But so far only the pledge part has been made.
China is no doubt holding out until it gets some clarity on greater voting power within the IMF. The IMF has long been a puppet of the US, with the balance of votes held by the legacy developed economies. China’s vote was recently raised before the GFC from about one-fifth of sweet FA to two-fifths, or something like that, but China has been promised a more representative share. Perhaps when that’s in the bag Chinese funding will be forthcoming.
China will then be afforded what will surely be an interesting chat with Fed chairman Ben Bernanke. The delegates will be keen to learn Bernanke’s plan for an “exit strategy” from the Fed’s massive monetary stimulus given China holds a sizeable proportion of US Treasury bonds. Yet for all China’s public criticisms and threats of withdrawal as a US creditor, Standard Chartered notes China is still adding to its US bond holdings and was first to turn up to mortgage-backed security auctions held recently.
Geithner will want to know about Wen Jaibao’s statement last week that China’s “going out” strategy – in which the government provides funding from its foreign reserve holdings to encourage direct investment of Chinese companies into foreign companies – should be hastened. Just like his Australian counterpart, Geithner will want to know whether “going out” means state-funded encouragement for commercial investments or whether it really means a takeover from “China Inc” – the state-owned enterprises.
And the problem of protectionism will no doubt rear its ugly head. Both sides are guilty of at least some level of thinly-veiled protectionism to date, so the argument should be a heated one.
In the wider scheme of things, Standard Chartered has just updated its currency outlook out to 2015.
In short, the analysts reiterate their belief the US dollar will continue to trend down from here as the global economy stabilises and risk appetite returns. This is exactly what happened after the US emerged from the 2002 recession, only in that case it was a burgeoning current account deficit (and aforementioned trade imbalance with not just China) that drove the dollar lower. This time it will be a burgeoning fiscal deficit.
The flipside will be an appreciation of the euro, the analysts suggest, although Europe still has to come to terms with the spectre of potential Eastern European economic failure. The yen, on the other hand, works in a counter-cyclical fashion given it is the traditional carry trade funding currency. As risk returns, the market will again sell yen to find risk investment. This will suit Japan in the shorter term because the last thing it needs now is an expensive currency to make its exports uncommercial.
While Geithner might be pleading otherwise, Standard Chartered believes China will not appreciate the renminbi until it does see a sustainable bounce in its export markets.
And all of that means a stronger Aussie.
