Geithner Assures China Reserves are Safe

During the first few days of the Obama administration, newly-minted Treasury Secretary Timothy Geithner made quite the stir when he charged China with “currency manipulation”. The US has long believed that China follows a policy of deliberately devaluing the yuan in order to maintain its trade advantage with the US, but Geithner’s accusation marked a dramatic – and public – shift from predecessor Henry Paulson’s softer approach to dealing with China.

Naturally, China was less than impressed with Geithner’s comments and used the days leading up to the G-20 summit last March to strike back. Suggesting that America’s increasing deficit and overall debt was reckless and unstable, Zhou Xiaochuan – Governor of the People’s Bank of China – called for a discussion on the feasibility of replacing the US dollar as the preferred reserve currency. As I noted in a commentary at the time, the G20 agenda was not changed to include this discussion, but China made its point nevertheless.

But that was then and this now, and since March, China has actually bought up even more US debt and now holds close to $770 billion – give or take a couple of billion. America’s budget deficit has grown much wider adding to a total debt closing in on $11.5 trillion even as the dollar continues to falter. Despite all this, the two countries have never before been so intertwined and notwithstanding some over-blown rhetoric on both sides, America and China both need a stronger US dollar if either country has any hope of meeting long-term growth plans.

Why China and America Needs a Stronger US Dollar

America’s need for a stronger dollar is obvious – as the world’s largest economy, the US is dependant on imports to meet many of its needs. This includes everything from consumer goods to crude oil and the weaker the dollar in relation to other currencies, the more it costs to buy many of these goods. As the world’s third largest economy, China depends on the US to buy its exports – in fact, the US is China’s largest export market representing sales of $338 billion in 2008. A weaker dollar – not to mention the ongoing recession in the US – threatens the purchasing power of the US and this has a direct and negative impact on China’s bottom line.

Naturally, goods flow both ways between the US and China, but the trade balance is certainly in China’s favor and this is one area that Geithner will surely ask for help while visiting with officials in Beijing. In 2008, the US had a negative trade balance of $266 billion due largely to the gap between the yuan and the dollar making American goods very expensive for Chinese consumers; it is this exchange rate gap that continues to lead to charges of currency manipulation against China. The US government believes that if China allowed the yuan to reflect true market influences, the yuan would appreciate making US products more affordable in China thus narrowing the negative trade balance. The resulting influx of money into the US would help lift the American economy out of the doldrums and would bring – if you believe Geithner – an earlier end to the global recession.

Of course, this would have negative repercussions on China’s economy but Geithner will argue this will be for the short-term only as a rejuvenated US economy with a stronger dollar will lead to an overall increase in China’s exports. What will China want in return? Certainly, China wants assurances that the US will do more to protect the dollar and by extension, China’s sizable investment in US currency – a fact that Geithner addressed early in his visit.

“We are very committed to make sure that when recovery is established, that we go back to living within our means, that we bring our fiscal deficits down to a sustainable level, that we unwind and reverse these exceptional measures that we’ve taking in the financial sector,” Geithner said in an interview with China’s state television.

In reality, not much will really come of Geithner’s visit – there will be the usual photo ops and pledges to work together for a common goal but monetary policies in both countries will remain largely unchanged. It is unlikely that China will allow the yuan to appreciate much beyond its current level – certainly not if the dollar keeps plummeting – and the US is in no position currently to address is massive debt. In fact, the US will need to issue more debt before the economy shows any tangible improvement, and this will force the Obama administration to address some difficult decisions with respect to taxes.

In order to increase revenue to deal with growing operational costs and to fund the programs the President wishes to implement, the government must collect more tax dollars. Given the fragility of the early stages of a recovery however, sharp tax increases could kill any rally before it gets firmly established.

Even in the face of these unknowns however, one thing is certain – the fortunes of both countries will continue to be closely aligned for many years to come.

This article is for general information purposes only. It is not investment advice or a solution to buy or sell securities. Opinions are the authors; not necessarily that of OANDA Corporation or any of its affiliates, subsidiaries, officers or directors. Leveraged trading is high risk and not suitable for all. You could lose all of your deposited funds.