Regardless of whether it is deemed good or bad, trade/currency conflict with China is a fact of life--but it doesn't fit standard models of "trade wars." To avoid unnecessary inflammation in the body politic, let's refer to this bundle of inter-related conflicts as "trade-currency issues" rather than a "trade war," which is a heavily loaded phrase that adds plenty of emotion and precious little understanding.

While many commentators warn that any trade war will lead to disaster (based on the negative consequences of higher tariffs slapped on international trade in the Great Depression), trade with China overflows the boundaries of this simple model of trade and tariffs. It may well be a "trade war" would be beneficial to both nations as long as it doesn't transmogrify into a "hot" shooting war.

To understand these conflicts, we can start by looking at a few of the major moving parts of trade between the U.S. and China. Trade and capital flows between the U.S. and China are complex and highly dynamic. Here are a few points to consider:

1. Since the renminbi (RMB or yuan) is fixed to the dollar, the pair trade as one unit against all other currencies. In a simple model of global trade and currency valuations, then all currencies are either fixed against a standard such as gold, or they float freely against each other.

Since China pegs its currency to the U.S. dollar, then neither model can make sense of the yuan-dollar pairing.

Given this pairing, China is less concerned about the consequences of their yuan peg on their trade with the U.S. than they are of the dollar-yuan's valuation against the Euro, Japanese yen, Korean won, etc.

If the dollar falls in value relative the euro, Chinese goods become cheaper in Europe. Since Europe is now a larger export market for China than the U.S. by a modest margin, that dynamic is critical to the Chinese leadership.

In other words, while self-absorbed American politicians can obsess about the yuan's peg, the Chinese have to worry about the dollar's moves against other major currencies.

It doesn't matter much where the yuan-dollar peg is set. As others have noted, jobs will not be moved to the U.S. from China if the yuan moves from 6.7 to 6. Prices on imported goods in the U.S. will rise modestly, and suppliers in China will receive fewer dollars.

What would concern China is not superficial changes in the yuan peg but a much stronger U.S. dollar. As the dollar gains in strength, so too does the yuan. A much stronger U.S. dollar would end up making Chinese goods more expensive everywhere except the U.S.

Ironically, a stronger or weaker dollar has virtually no effect on the cost (in dollars) of goods from China, as the yuan is pegged to the dollar. The action is thus all on the dollar and its relative value in euros, yen, etc.

2. Much has been written about China's "nuclear option" of dumping its $850 billion in U.S. Treasuries to "punish" the U.S. for its demands. Suffice it to say that this "nuclear option" is more a firecracker than a weapon of financial mass destruction. (Please see China's "Nuclear Financial Option" Downgraded to "Financial Firecracker" September 2, 2010 for more.)

In essence, the Federal Reserve can create as much money as it deems necessary to buy whatever assets it deems necessary. In 2009 the Fed decided to expand its balance sheet by $1.2 trillion to buy $1.2 trillion in mortgage-backed securities to prop up the U.S. housing market, and it did so without any panic or global consequences.

Thus the Fed could soak up China's entire $850 billion stake of Treasuries at will. That only represents 10% of outstanding Treasuries, and the Fed would only have to expand its balance sheet from $2.3 trillion to $3.1 trillion to do so. In the larger scheme of things, this is really no big deal.

I know many think it should be a big deal, but global markets issued a bored yawn over the last $1.2 trillion expansion in the Fed's balance sheet. Another $800 billion simply isn't enough to make much of a ripple.

The currency markets trade several trillion dollars of currencies a day. $800 billion is sizeable but it's really not that big in today's global markets. Even after the stock and housing market's declines, there is $52 trillion in net worth in the U.S. China's Treasuries represent about 1.5% of that.

If we grasp that what matters to China is the dollar's relative value to its other trading partners' currencies, then we reach a new understanding. What would cause China to dump Treasuries is not a desire to "punish" the U.S. but to weaken the dollar globally to keep Chinese goods cheap in Japan, Europe and elsewhere.

Many in America share this same goal: keep the dollar weak. In this sense, China and the U.S. are "allies" which are bonded by the yuan-dollar peg into a partnership against all other currencies and trading blocks.

Thus the yuan-dollar peg is more a sideshow played out for the domestic audiences in the U.S. and China. China's leaders don't want to "lose face" with their populace by seeming to cave in to U.S. demands, and American politicos desperately want to to appear "strong" with China to give the illusion that
1) they "care" about "creating jobs" in the U.S. (hahaha)
2) the "problem" is the yuan-dollar peg (it isn't)
3) they deserve being re-elected because they're "taking a strong stand" on this (worthless, nonsensical "issue" that won't create a single job--barf!)

Thus we can predict this issue will magically disappear after the November elections. The whole Kabuki play is staged direct from Central Casting: Inscrutable Chinese leaders, blustering know-nothing U.S. Congressmen hoping to leverage a tempest in a teapot into another term in power, and so on.

What would cause a real conflict between China and the U.S. is a true "strong dollar" policy. If the U.S. leadership changes in either 2010 or 2012 and the new leadership grasps the folly of beggar-thy-neighbor currency wars, then the U.S. might seek to strengthen rather than weaken the dollar. Were that to occur, China would soon suffer a major decline in global competitiveness as the U.S. dollar rose in value.

The lesson here is the advertised "conflicts" may mask both the differing interests and unstated partnerships between China and the U.S.

There is much more to be said on these topics, but I will close today's entry by noting that the key feature of capital flows between China and the U.S. is this: the U.S. in effect exports credit to China, and imports goods and dollars back. This trade in credit is reflected in the "real world" exchange of goods and currencies. While many commentators have noted that foreign trade flows must balance--China has to "recycle" its excess dollars back to the U.S.--the real issue isn't currencies, it's the credit underlying the trade itself.

More on these topics tomorrow. Here are some recent entries on China:

Why China's Housing Bubble Is Unsustainable (September 16, 2010)

China's Real Estate: Black-Hole Capital Trap (July 14, 2010)

China's Towers and U.S. McMansions: When Things Fall Apart (Literally) (April 14, 2010)

China and the U.S.: Dysfunctional Real Estate Bubble Twins (January 21, 2010)

The Myth of "Decoupling" and the Chinese Consumer (September 14, 2010)

Life has put on a full-court press, and while I read every email I am unable to respond to all correspondence. Hopefully Life reverts to a half-court press soon. (Please excuse the basketball analogy.)


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