China will not be bullied into revaluing the yuan

China will eventually let the yuan rise, but not because its trade partners told Beijing to do it. When China’s leaders let the yuan rise it will be because they perceive it to be in the interest of the political establishment.

With the US Treasury due to issue its annual report on currency manipulators soon and elections around the corner, a new rash of China bashing has broken out in Washington. But China insists as much as ever that the yuan is not undervalued. As a result, a dangerous game of brinkmanship has emerged at the heart of the most important economic relationship in the world, raising the chances of a nasty trade war.

The new push in Washington for sanctions against China is more about domestic politics than anything else, with China an easy target for politicians eager to build up political capital ahead of the mid-term elections amid high unemployment and general anxiety about China’s rise. But likewise, China’s refusal to revalue the yuan is also driven by Chinese politics. Chinese leaders don’t want to be perceived by the population as kowtowing to the United States or other western countries, which would undermine their credibility and make cracks in their power.

It is frequently said of China that the Chinese have a much longer sense of history than in the West, which makes them see the world through the prism of history. Therefore, the Chinese consider it vital to put the last 200 years of foreign domination behind them and restore China’s position as one of the world’s pre-eminent powers — a position China enjoyed for millenia until the Europeans arrived. Prior to the arrival of Europeans, the Chinese leadership considered it to be at the centre of the world, literally the Middle Kingdom. However, a student of Chinese history will quickly see that the central powers have long struggled to maintain authority over the country and surrounding territories, causing the imperial leadership to frequently collapse and uprisings to break out.

The current Chinese leadership know that to retain authority, and therefore credibility, with the population they must firstly deliver prosperity through rapid economic development and secondly they must be perceived as restoring China to its former glory as a pre-eminent power. And, as Americans themselves know perfectly well, pre-eminent powers do not let their policies be dictated by foreigners.

That is why the Chinese leadership are refusing to re-value the yuan even as it increasingly makes sense for the Chinese economy. With inflation in China becoming a problem and asset bubbles getting bigger every day, relaxing the yuan’s exchange rate makes good economic sense. But it does not yet make good political sense. It will make political sense when the economic damage from the yuan’s overvaluation becomes more of a domestic threat to the Chinese leaderships credibility than the perception in China that revaluing the yuan is kowtowing to Washington and other foreign powers.

In the mean time, bullying China to revalue the yuan can only be counterproductive because it would only make the Chinese leadership look weak if they actually did it.

Is Germany the China of Europe?

It’s an international economic powerhouse sporting a trade surplus the envy of most other nations. It’s workers are industrious and it’s consumers are thrifty. And it’s trade strategy is getting on the nerves of its major trade partners.

The parallels between the German and Chinese economies stop there. But French Finance Minister Christine hit on a something when she very undiplomatically attacked Germany in an interview with the Financial Times for building its huge trade surplus on holding down wage costs. Such criticism is certainly familiar to the Chinese.

For Germany, an export driven economy coupled with high savings and stagnant wage growth would not be so irritating for other countries except that Germany is in a currency union with 15 other countries. And if Germany runs a big trade surplus, it means that its main trade partners, who are mostly in the eurozone, must run a big trade deficit. And if Germans save everything they can, that’s money they don’t spend on consumption of imports from the rest of the eurozone or vacations in Greece, Spain or Portugal. And when German employers keep wages from growing year after year, they become much more attractive than their competitors in erstwhile poorer eurozone countries like Greece, Spain and Portugal.

Of course, divergences between countries are normal. After all the southern Europeans could have done more to make their economies more competitive. However, such divergences become a problem in a shared currency union such as the eurozone. For instance, they explain how Germany has been able to run its public finances much better over the last five years than southern European countries. Such divergences also mean that smaller countries on the fringes of the eurozone were stuck with interest rates more appropriate for Germany, helping to create housing bubbles in Spain and Ireland.

Of course, the real target of Lagarde’s criticism in the FT interview is Germany’s stubborn budget discipline. What she wants is Berlin to do like Paris and worry less about its budget deficit and do more to kick start domestic consumption, which would benefit not only Germans but people in other eurozone countries. In other words, give Germans a raise if you want to help Greece.

China not dumping dollars… yet

The press has made much out of US Treasury data last week indicating China’s holding of US treasury bonds fell by 34.2 billion dollars in December, suggesting either openly or by implication that Beijing is dumping the dollar. While the drop in Chinese holdings does raise many questions, such speculation ignores the basic facts about why China purchase’s treasury bonds in the first place.

China buys US treasury bonds in order to keep the value of the yuan to the dollar fixed. Therefore, if the Chinese suddenly got cold feet about the dollar and dumped a chunk of their holdings then the yuan’s exchange rate to the dollar should have changed in December. That clearly did not happen as it would have been huge news. The yuan is just as fixed to the dollar as ever although there are good reasons to expect that to change in the coming months.

There are other explanations for the fall in Chinese holdings. One possibility is that the Chinese central bank chose to purchase treasuries indirectly through US or foreign banks, which would keep the purchase from showing up in the Treasuries data for direct purchases by China. Indeed, holdings of US treasuries by Britain — with London the home of many international banks — rose by 24.9 billion dollars in December, which would offset a big chunk of the fall in Chinese holdings.

The question then arises why would the Chinese opt for a more roundabout way to manage their US holdings, especially since it would increase the transaction costs for them. Perhaps, it is a new way of sending Washington a message. Chinese officials have been voicing concern about the dollar and the spiraling US deficit for sometime. So maybe this is a way of putting their money where their mouths are, both figuratively and literally, since actually dumping the dollar is not possible without relaxing the yuan’s peg to the dollar. Moreover, tensions between China and Washington have been high and rising, getting in fact substantially worse since the December period covered  by the data.

But there is also another more mysterious possible reason for the fall in Chinese holdings of US treasuries. Since the Chinese have to buy dollar assets in order to keep the yuan pegged, perhaps they have bought US assets other than low-yielding treasury bonds. In which case, what did they buy? Corporate bonds, stocks… One can hardly blame the Chinese for trying to get a better return on their investments in US assets given the rock-bottom rates on offer from the Treasury. Indeed, even in regard to its treasury holdings, China has been cutting down on low-yielding treasury bills in favor of higher-yielding, longer term notes. That can also be said of all foreign holders of US government debt.

While sharp for one month, the drop in Chinese holdings also has to be put into context of the trend over several months. Chinese holdings peaked in May 2009 at 801.5 billion dollars and have been drifting down since then although December’s fall was bigger than previous months. However, that fall in Chinese holdings has easily been offset in increases by Britain and Japan, which regained its title as the US government’s biggest foreign creditor from China in December.

Therefore, the US is still having no problem attracting the foreign capital it needs to finance its vast current account deficit.

Is Japan replacing China as the US’ biggest creditor?

China is the United States’ biggest creditor, right? Everyone knows that, at least everyone who cares about that sort of thing. Well, if current trends keep up, then apparently Japan could reclaim the dubious title of top creditor to the US government, if US Treasury data released today are anything to go by.

Those data (http://www.treas.gov/tic/mfh.txt) show that China’s holding of US Treasury securities fell in November from October by 9.3 billion dollars to 789.6 billion dollars, slipping further away from a peak of 801.5 billion dollars reached back in May 2009. Meanwhile, Japan’s holdings continued to climb in November, rising to a tidy little sum of 757.3 billion dollars, up from 745.9 billion in October.

It is indeed a strange world where one of the most highly indebted countries in history can become the biggest creditor to another one of the most highly indebted countries in history. At least if China loses the top creditor title, Beijing will be delighted to see US politicians and journalists finding it more difficult to vilify it as some sort of giant Shylock, which will help take some pressure off its leaders as they try to figure out how to let the yuan appreciate.