Before President Barack Obama touched down in China for his three-day visit this week, the country's top banking regulator joined the ranks of those complaining about the U.S. Federal Reserve's low interest rates and the falling dollar. The combination, said Liu Mingkang, has fed speculation in stock and property markets (especially in Asia) and threatens the worldwide economic recovery.
What can China do about it? As long as the country banks on Americans to buy Chinese products, economists say, not much.
"They don’t have any credibility," said Dan Greenhaus, chief economic strategist at Miller Tabak. China has played the same game for years, keeping its currency cheap so that other countries will buy its goods. The U.S. certainly cares about what its largest creditor thinks, Greenhaus said, but has little reason to change course. A cheaper currency boosts U.S. exports, just as it does for China, and the Federal Reserve won't raise rates at the risk of choking the economy.
The two countries are effectively locked in an embrace: China buys U.S. debt and the U.S. buys China's goods. "It's a symbiotic relationship," Greenhaus said.
The Fed has kept interest rates low to spur borrowing and encourage economic growth, thereby creating a new carry trade. Investors borrow cheap dollars and lend them in a currency from a country with a higher yield and then pocket the difference. The Dollar/Aussie carry trade has been especially popular since the Australian central bank raised interest rates to 3.5%. Each trade sells U.S. dollars to buy Aussies and helps push the dollar lower and the Aussie higher. Remember this next time an analyst says that the Aussie is climbing because Australia is commodities-rich--there's some truth to it, but there's also some momentum at work.
When the dollar falls, China rushes into the market to keep its currency close to 6.84 to the dollar, selling the yuan to buy assets priced in dollars. Letting the dollar weaken against the yuan would make Chinese products more expensive to American consumers, so China keeps its currency pegged and, as a result, has piled up more U.S. debt than any other country. At last count, China held $797 billion in Treasury securities, up from $573.7 billion in August 2008.
The largest creditor to the U.S. would appear to have plenty of leverage, the ability to wreak havoc if it doesn't get its way. The nightmare scenario, as imagined by the doomsayers, has China selling off its vast store of Treasury notes or maybe refusing to show up to the next Treasury auction. Yields on Treasury debt skyrocket, the U.S. defaults and Americans wake up in a Cormac McCarthy novel.
But in reality, China has too much to lose to make any rash moves, said Carl Weinberg, chief economist at High Frequency Economics. If it stopped buying U.S. debt, the value of its $797 billion Treasury hoard would plummet along with the dollar. A soaring yuan would also hurt exports, which have dropped for 12 months in a row. That's one reason China rejects cajoling from the Obama administration to let its currency float freely.
If it wants to fight an asset bubble, the People's Bank of China could begin raising rates by the middle of next year, say researchers at JPMorgan Chase. And the bank recently hinted that it would allow for more flexibility in its exchange rate. Don't expect much. JPMorgan's researchers estimate one dollar could fetch 6.5 yuan by the end of next year.