CURRENCY CONSIDERATIONS AT THE U.S. - CHINA SUMMIT / ROUBINI GLOBAL ECONOMICS´ WEDNESDAY NOTE ( HIGHLY RECOMMENDED READING )

CURRENCY CONSIDERATIONS AT THE U.S. - CHINA SUMMIT

Greetings from RGE!

Given that the U.S.-China Strategic and Economic Dialogue (S&ED) will recommence in Beijing on May 24, 2010, we wanted to take the opportunity to focus in on RGE’s coverage of U.S.-Chinese bilateral relations. The bulk of the following note is excerpted from a new RGE Analysis, available to clients, examining the prospects for the dialogue. We also wanted to highlight a new monthly feature, China Focus, which examines the implications of China’s monthly data releases. The most recent installment, released earlier this month, assesses when to expect Chinese interest rate hikes.

Now, turning back to the summit:

A year packed with diplomatic drama has moved the goals slightly for both sides in the 2010 dialogue, the second time the annual U.S.-China parley has convened since the Obama administration took office. China’s diplomats came to Washington last year ready to blame the U.S. financial system for the global recession. This year China’s economic recovery is on more solid ground and even overheating, putting Beijing on the defensive just as high unemployment and looming mid-term elections increase the pressure on U.S. negotiators to take a hard-line approach.

The last S&ED opened with a discussion on climate change, kicking off a process the Obama administration clearly expected to lead to a multilateral deal supported by China at the Copenhagen summit. That strategy fizzled: expect U.S. policymakers at the upcoming summit to downplay the importance of China’s cooperation on environmental issues in Beijing. Instead, cooperation on Iran and other geostrategic concerns may take the limelight in the security sphere, added to other concerns on energy supply. The previous meeting also came at the height of concerns about the sustainability of the USD as a reserve currency, a story Beijing saw in its interest to peddle at the time. This year the renminbi (RMB) will be the currency in the spotlight, while the euro, once touted by Chinese analysts a year ago as a possible dollar alternative, is now the “reserve currency” under fire due to the European Union’s debt woes.

Still, the agenda this year bears similarities to the 2009 edition. Trade and savings imbalances will dominate the economic talks; Iran’s nuclear ambitions, reviving “Six-Party Talks” with North Korea and energy concerns will top the strategic dialogue. Few concrete deliverables are expected on any of these issues, especially considering both sides prefer to do the heavy lifting through lower-profile bilateral exchanges. However, the importance of the S&ED is not the agreements that dialogue can bring to the table; rather it’s that it brings the top Chinese and American policymakers to the table. A frank exchange between those at the commanding heights of the world’s two largest economies will always be worth the trip.

With respect to the RMB, it was just over a month ago that the U.S. rhetoric on the Chinese currency’s valuation came to a boil as the U.S. Treasury prepared to release its biannual report on currency manipulation. U.S. senators heard testimony from leading economists on why China should be labeled a currency manipulator, and they threatened punitive sanctions if Treasury Secretary Tim Geithner failed to act. Chinese rhetoric also hardened as leaders played to a domestic audience at the National People’s Congress in March. A diplomatic reshuffle in China added to the tensions as it left U.S. policymakers unsure who to call to deescalate the situation. After the major appointments were settled, an hour-long phone call between Hu and Obama kicked off a series of exchanges that rapidly cooled off the situation. Whether due to a quid pro quo or simply a shift in domestic politics, within a fortnight, Geithner was in Beijing meeting with his rough counterpart, Vice Premier Wang Qishan, and the currency report was shelved.

If a deal was reached during these weeks of diplomatic derring-do, it has yet to show up in the currency markets. The RMB remains pegged to the USD, though concerns about the EUR have boosted the Chinese currency’s valuation on a trade-weighted basis in any case, which could forestall a move or limit its degree. U.S. officials have said they will discuss the RMB/USD peg in the economic talks at the S&ED, but RGE expects the public rhetoric to remain muted. China’s Q1 2010 reserve growth, which was US$95.6 billion after adjusting for changes in valuation, showed that appreciation pressure remains high.
As we have long argued, China is likely to move on the currency around the middle of this year, but it will do so on its own terms. Consumer inflation remains rather muted, though producer prices are up more sharply due to higher commodity prices. We expect the CPI to cross policymakers’ 3% y/y threshold in May, which will be followed shortly by RMB appreciation and a 27-basis-point interest rate hike, though the exact timing of each measure is uncertain. The diplomatic schedule complicates the currency move, with the S&ED followed by the G20 summit in Canada in June. China will likely try to avoid all appearances of caving to international pressure, which at this point seems to suggest July makes sense for RMB appreciation. If that is the case, June will likely see a 27-basis-point rate hike, a move China’s economy desperately needs.

Behind closed doors, Chinese leaders will repeat their complaints about the USD’s role as a reserve currency and their concerns about the safety of their massive U.S. Treasury holdings (about US$1 trillion) given the eroding U.S. fiscal position. For now, there are few other choices. However, the U.S. will struggle to prove it has a workable long-term plan to reduce the fiscal deficit. These constraints will contribute to the softness of the U.S. approach to the RMB.


Roubini Global Economics 131 Varick Street, Suite 1005 New York, New York 10013 Tel: 212.645.0010 Fax: 212.645.0023