Robert Portman, the newly minted U.S. trade representative, promises to get tough with China. Red ink is the reason.
“Part of [the U.S. trade] deficit is because the Chinese do not always play by the rules,” he told the Senate Finance Committee via Bloomberg News a week before he received confirmation for ascension to the trade post from his former life as a Republican congressman from Ohio.

The presumption is that by getting tough with China, which includes forcing the Middle Kingdom to float its currency, the U.S. trade deficit will fade, if not disappear. That, in turn, will remove pressure from the beleaguered buck and lessen the momentum for raising interest rates to maintain the dollar’s competitive allure in foreign exchange markets.
Indeed, the dollar’s been rising this year in part because interest rates in the United States have been increasing on a relative and an absolute basis. Fed funds today stand at 2.75%, and presumably will move to 3.0% tomorrow once the Federal Open Market Committee all but confirms the much-anticipated 25-basis-point rate hike planned for Tuesday.
Oh, how things have changed. A year ago, Fed funds were 1%, while the equivalent European Central Bank rate was 2.0%. The ECB rate remains at 2%, which is to say America now leads Europe in the category of yield premium for short-term rates. That explains some, if not most of the zing in the 4.5% rise in the U.S. Dollar Index this year, and in the process reverses the euro’s former aura of destiny in marching over the greenback.
But better living through higher interest rates has its limits. The Fed can’t raise rates too far, too fast without risking a recession. And in light of last week’s lower-than-expected GDP report, recession is suddenly a topic of renewed focus in circles economic.
On the other hand, there are many tools at the government’s disposal beyond the monetary levers, and pressure is building on Portman and others in the administration to use a few of them. One school of thought seems to be that if China’s growing imports are the problem, the answer must be to float the Chinese yuan and thereby nip the problem in the bud.
Clearly, artificial intervention by China has kept its currency weaker than it otherwise would be relative to the dollar. That’s no great surprise, considering that the Chinese economy was growing some three times as fast vs. the U.S. economy.
There’s a method to China’s madness, namely, engineering a weak currency keeps imports flowing to the U.S., and keeps them flowing at prices lower than they’d be if the yuan was allowed to seek the higher level that it almost surely would aspire to in a free market.
That higher level in fact is the immediate goal for the Coalition for a Sound Dollar, which represents more than 100 American manufacturing and agricultural trade groups. The industries represented by those trade groups are invariably being squeezed by imports generally, and Chinese imports into the U.S. in particular. Or so one assumes based on comments issued by the Coalition—like this one from April 22:

The Coalition for a Sound Dollar today commended President George Bush and Treasury Secretary John Snow for their statements this week asserting that China must act now on currency reform. “We view this as a very significant change in remarks by the Administration,” said Patricia Mears, spokesperson for the Coalition. “This is a shift from ‘China should do it sometime” to ‘They should do it now.’
Mears said the next step is for the Treasury Department, in its report to Congress due later this month, to cite China publicly for manipulating its currency and immediately proceed to initiate negotiations on an expedited basis, as required by statute, to press them to eliminate the undervaluation of their currency that burdens their trading partners’ economies as well as their own.

The China Currency Coalition is another group similarly disposed. “The undervalued yuan continues to push the bilateral deficit to record heights, depressing employment in the manufacturing sector and threatening the global financial system” David A. Hartquist, spokesperson for the coalition, recently stated. “Global markets cannot sustain the accelerating imbalances that result, in large part, from China’s undervalued exchange rate.”
Perhaps, but one could reasonably ask if the United States economy sustain a revaluation of the yuan to market rates?
Revaluing the yuan upwards would almost certainly reprice Chinese goods upward as from a dollar-based perspective. And higher prices, presumably, would shift more demand to U.S. companies at the expense of Chinese companies.
But there are no free lunches in the global economy, least of all from a free-floating yuan. For starters, it’s not clear that reduced Chinese imports to the U.S. will result in an automatic increase in sales for domestic firms. As Kristen J. Forbes, a former member of the President’s Council of Economic Advisers, said in testimony to Congress last month via The Washington Post: Increased imports from China “largely reflect decreased imports of the same goods from other countries. In fact, much of China’s recent increase in U.S. import share has come largely at the expense of Japan.” What’s more, employment in the United States has risen as imports from China have increased.
But that’s not necessarily going to sway the Bush administration. U.S. Under Secretary John Taylor seems eager to have China float its currency. “We have very much stressed that they can begin to have a flexible exchange rate right now,” he says courtesy of Reuters. That’s diplomatic speak for suggesting that Beijing float sooner rather than later.
Perhaps the biggest risk for the United States from a free-floating yuan is the creation of new incentives, or should we say disincentives, for China when it comes to buying dollar-based assets above and beyond what prudent economic thinking dictates. China, you may have heard, is the second-largest foreign holder of Treasuries after Japan. This despite the falling greenback, which eats into the value of China’s Treasury portfolio.
So, you may ask, why would China engage in self-imposed losses? That is, why would China continue to buy and hold Treasuries when such holdings have shown a clear and distinct pattern of losing money in recent years? Because holding those Treasuries keeps the yuan’s value from rising in dollar terms, which promotes Chinese exports, which in turn more than offsets any losses from dollar holdings.
China, in other words, wants to sell us goods at below-market rates by financing the country’s budget and trade deficits through Treasury purchases. Some in the United States are upset with that arrangement and would prefer to pay more for those goods as a short-cut to shifting production back to U.S. companies. Even assuming that outcome is likely, the “solution” risks becoming a Pyrrhic victory if China rethinks its seemingly irrational Treasury purchases.
Ergo, America depends heavily on the willingness of foreigners to finance a large chunk of its economic momentum, such as maintaining the all-important consumer spending machine by way of keeping interest rates lower than they’d otherwise be. Perhaps it’s time to ask, If not China, who? Maybe Japan could pick up the slack and buy more Treasuries. Indeed, the Land of the Rising Sun already harbors some $700 billion of the Treasuries paper. How soon could Tokyo assume another $200 or so billion that now reside in China?
Arguably, some in Congress haven’t asked that question, or perhaps they’ve already dismissed it, based on the recent introduction of the Chinese Currency Act of 2005, legislation designed to make “China accountable for the serious adverse impact that its exchange-rate manipulation and resultant currency undervaluation have on imports into the United States from China.”
Paul Kasriel, director of economic research at Northern Trust, has thought long and hard about just these issues and written more than a few times on the implications. But that doesn’t mean he’s not perplexed by the legislation intended to force the yuan to float. “It’s amazing that our Congress putting pressure on Chinese to do this,” Kasriel tells CS.
No matter, Kasriel and others think the dollar’s going to fall regardless over time. But if some in Congress and the administration have their way, it may fall faster and deeper than they expect.
The yuan is surely destined to be a free-floating currency. Exactly when is anybody’s guess. But as China becomes increasingly dependent on capitalism, a fixed currency won’t, can’t last forever. But forcing Beijing’s hand in the here and now may not be the smartest trick in the book at this juncture. It’s probably not even likely for the time being. No matter, a government “rescue” may be coming one day, like it or not.