Did U.S. and China strike a currency deal?

   on October 25 2010 9:12 PM

The meeting of G20 finance ministers over the weekend did not produce any concrete policies to address the global currency war. However, behind the scenes, China and the U.S., the two major combatants, may already have already struck an agreement, said Douglas Borthwick, head trader of Connecticut-based Faros Trading.

Borthwick thinks China and the U.S. may have agreed to gradually appreciate the Chinese yuan over 5 years.  This could occur at an average annual rate of 7.8 percent, which would amount to 40 percent at the end of 5 years.  Western academics estimate the yuan is currently 30 to 40 percent undervalued.

 

This plan is similar what happened from 2005 to 2008, during which the yuan appreciated over 20 percent over the U.S. dollar.  (That appreciation stopped in July 2008, when China re-pegged it to the dollar).

 

Contrastingly, it is different from the 1985 Plaza Accord, in which leading countries openly agreed to revalue currencies and the Japanese yen rallied over 50 percent in against the U.S. dollar in just two years. 

 

China favors a gradualist approach, and it may have convinced the U.S. that a one-off revaluation of the [yuan] is neither China's nor the US' interest, said Borthwick. 

 

Indeed, the fiery rhetoric from China against yuan appreciation revealed its opposition to sudden or rapid moves.  Early October, Chinese Premier Wen Jiabao said if the yuan isn't stable, it will bring disaster to China and the world.

 

Yao Jian, a spokesperson for China's Ministry of Commerce, said at a press conference in Beijing that Japan's rapid appreciation under the Plaza Accord led to high unemployment, an economic slowdown, and the subsequent monetary loosening fueled its disruptive asset bubble.

 

U.S. Secretary Timothy Geithner may have acquiesced to the gradualist approach in early October; he said the yuan should appreciate at a gradual but still significant rate, according to the Wall Street Journal.

 

The U.S.-China currency war, therefore, may be a protracted five-year struggle.  During  this constant tug-of-war, the U.S. will push for faster appreciation and China will push back.

 

One weapon the U.S. has is quantitative easing, which is theoretically unlimited.  When it is employed, it floods China with capital, which makes it harder to keep the yuan's value down. 

 

Analysts believe the Federal Reserve will employ a flexible quantitative easing program in which the amount of assets purchased can be adjusted each meeting.  Borthwick said this structural allows gentle prodding from the U.S., which can step up asset purchases whenever it feels yuan appreciating is progressing too slowly.

 

The yuan appreciating 40 percent against the U.S. dollar may go a long way in rebalancing the global economy.  Borthwick said in the five-year period, the U.S. can rebuild its export sector and China can build domestic demand and financial markets. 

 

But it's not just about China; many emerging market countries benchmark their currencies to the Chinese yuan because China is the world's largest exporter and second largest economy.  Therefore, if the yuan appreciates , it may lead to an across-the-board emerging market currency appreciation, which could distribute consumption from the U.S. to emerging market economies. 

 

However, the results of the 1985 Plaza Accord serves as a somber warning.  The agreement did achieve its objective of depreciating the dollar against the Japanese yen; however, not only did it fail to solve the United States' trade deficit problem, it also hurt Japan's economy, as Yao Jian mentioned.

 

 

Email Hao Li at hao.li@ibtimes.com

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