I think Ben Bernankeâ??s speech in Frankfurt today on global imbalances, and Chinaâ??s role in particular, marks an important turning point in international economic diplomacy. In his speech, Bernanke politely but directly accuses China of artificially undervaluing its currency in order to obtain unfair trade advantages at the expense of the rest of the world. This speech represents the most pointed and direct attack on Chinese currency and trade policy yet by a top US official, and the clarity and tone with which the accusations were made serve as a clear sign that there will be no backing down from this fundamental manner of framing of the issues.Recent speeches by US President Barack Obama and Treasury Secretary Tim Geithner have also been turning up the heat on Chinese trade and currency policies. Large gains by the far-right in the US Congress make it highly likely that the Obama administrationâ??s and the Fedâ??s increasingly aggressive posture toward China will find concrete expression in various legislative initiatives designed to address the USâ??s large trade imbalance and Chinaâ??s role in particular. I see Bernankeâ??s speech as an unequivocal sign that US officials are becoming increasingly united and determined to confront China on its predatory trade and currency policies.As a result, I now believe that the diplomatic relationship between China and the US has reached a critical inflection point. As things now stand, I believe that either China preemptively makes very significant concessions in the next few months or major and unpredictable consequences will follow. Framing the ProblemThe manner in which a problem is framed will largely determine how it will be addressed.In reading Bernankeâ??s most recent speech, I was somewhat startled by the remarkable similarities between his framing of the problem of Chinaâ??s currency and trade policies and the one put forth in my article Is Chinese Currency Policy a Form of Protectionism? published on October 19. Even the historical analogies Bernanke utilized were remarkably similar.It is important for investors to understand how the problem is being framed in order to be able to anticipate potential policy responses and implications. See the article here, and also excerpts from Bernankeâ??s Speech -- â??Rebalancing the Global Recoveryâ? -- below.
In sum, on its current economic trajectory the United States runs the risk of seeing millions of workers unemployed or underemployed for many years. As a society, we should find that outcome unacceptable. Monetary policy is working in support of both economic recovery and price stability, but there are limits to what can be achieved by the central bank aloneâ?¦. Unfortunately, the differences in the cyclical positions and policy stances of the advanced and emerging-market economies have intensified the challenges for policymakers around the globeâ?¦The exchange rate adjustment is incomplete, in part, because the authorities in some emerging-market economies have intervened in foreign exchange markets to prevent or slow the appreciation of their currencies.â?¦ A key driver of thisâ?¦is official reserve accumulation in the emerging-market economiesâ?¦ The total holdings of foreign exchange reserves by selected major emerging-market economies... have risen sharply since the crisis and now surpass $5 trillion -- about six times their level a decade ago. China holds about half of the total reserves of these selected economies, slightly more than $2.6 trillion. It is instructive to contrast this situation with what would happen in an international system in which exchange rates were allowed to fully reflect market fundamentals. In the current context, advanced economies would pursue accommodative monetary policies as needed to foster recovery and to guard against unwanted disinflation. At the same time, emerging market economies would tighten their own monetary policies to the degree needed to prevent overheating and inflation. The resulting increase in emerging-market interest rates relative to those in the advanced economies would naturally lead to increased capital flows from advanced to emerging economies and, consequently, to currency appreciation in emerging-market economies. This currency appreciation would in turn tend to reduce net exports and current account surpluses in the emerging markets, thus helping cool these rapidly growing economies while adding to demand in the advanced economies. Moreover, currency appreciation would help shift a greater proportion of domestic output toward satisfying domestic needs in emerging markets. The net result would be more balanced and sustainable global economic growth. Given these advantages of a system of market-determined exchange rates, why have officials in many emerging markets leaned against appreciation of their currencies toward levels more consistent with market fundamentals? The principal answer is that currency undervaluation on the part of some countries has been part of a long-term export-led strategy for growth and development. This strategy, which allows a country's producers to operate at a greater scale and to produce a more diverse set of products than domestic demand alone might sustain, has been viewed as promoting economic growth and, more broadly, as making an important contribution to the development of a number of countries. However, increasingly over time, the strategy of currency undervaluation has demonstrated important drawbacks, both for the world system and for the countries using that strategy. First, as I have described, currency undervaluation inhibits necessary macroeconomic adjustments and creates challenges for policymakers in both advanced and emerging-market economies. Globally, both growth and trade are unbalanced, as reflected in the two-speed recovery and in persistent current account surpluses and deficits. Neither situation is sustainable. Because a strong expansion in the emerging-market economies will ultimately depend on a recovery in the more advanced economies, this pattern of two-speed growth might very well be resolved in favor of slow growth for everyone if the recovery in the advanced economies falls short. Likewise, large and persistent imbalances in current accounts represent a growing financial and economic risk. Second, the current system leads to uneven burdens of adjustment among countries, with those countries that allow substantial flexibility in their exchange rates bearing the greatest burden (for example, in having to make potentially large and rapid adjustments in the scale of export-oriented industries) and those that resist appreciation bearing the leastâ?¦The current international monetary system is not working as well as it should. Currency undervaluation by surplus countries is inhibiting needed international adjustment and creating spillover effects that would not exist if exchange rates better reflected market fundamentals. In addition, differences in the degree of currency flexibility impose unequal burdens of adjustment, penalizing countries with relatively flexible exchange rates. What should be done? â?¦Rebalancing economic growth between the advanced and emerging-market economies should remain a common objective, as a two-speed global recovery may not be sustainable. Appropriately accommodative policies in the advanced economies help rather hinder this process. But the rebalancing of growth would also be facilitated if fast-growing countries, especially those with large current account surpluses, would take action to reduce their surpluses, while slow-growing countries, especially those with large current account deficits, take parallel actions to reduce those deficits. Some shift of demand from surplus to deficit countries, which could be compensated for if necessary by actions to strengthen domestic demand in the surplus countries, would accomplish two objectives. First, it would be a down payment toward global rebalancing of trade and current accounts, an essential outcome for long-run economic and financial stability. Second, improving the trade balances of slow-growing countries would help them grow more quickly, perhaps reducing the need for accommodative policies in those countries while enhancing the sustainability of the global recovery. Unfortunately, so long as exchange-rate adjustment is incomplete and global growth prospects are markedly uneven, the problem of excessively strong capital inflows to emerging markets may persist. As currently constituted, the international monetary system has a structural flaw: It lacks a mechanism, market based or otherwise, to induce needed adjustments by surplus countries, which can result in persistent imbalances. This problem is not new. For example, in the somewhat different context of the gold standard in the period prior to the Great Depression, the United States and France ran large current account surpluses, accompanied by large inflows of gold. However, in defiance of the so-called rules of the game of the international gold standard, neither country allowed the higher gold reserves to feed through to their domestic money supplies and price levels, with the result that the real exchange rate in each country remained persistently undervalued. These policies created deflationary pressures in deficit countries that were losing gold, which helped bring on the Great Depression. The gold standard was meant to ensure economic and financial stability, but failures of international coordination undermined these very goals. Although the parallels are certainly far from perfect, and I am certainly not predicting a new Depression, some of the lessons from that grim period are applicable today. In particular, for large, systemically important countries with persistent current account surpluses, the pursuit of export-led growth cannot ultimately succeed if the implications of that strategy for global growth and stability are not taken into account. Thus, it would be desirable for the global community, over time, to devise an international monetary system that more consistently aligns the interests of individual countries with the interests of the global economy as a whole. In particular, such a system would provide more effective checks on the tendency for countries to run large and persistent external imbalances, whether surpluses or deficitsâ?¦ Without such a system in place, the countries of the world must recognize their collective responsibility for bringing about the rebalancing required to preserve global economic stability and prosperity.
ConclusionThe Chinese policy of artificially undervaluing its currency for unilateral gain has been correctly identified by US officials as a violation of proper â??rules of the gameâ? and as a major impediment to the recovery of US growth and employment. This manner of framing the problem makes a showdown with China over trade and currency policy increasingly inevitable.How will the US and the global economy fare if the issue comes to a head? There can be no question that a serious trade and or currency confrontation would cause major disturbances in global markets. Thus, investors should be prepared for this prospect. However, from a longer-term macroeconomic perspective, as I have pointed out in various articles such as, Op-Ed: Is China Your Daddy?, China has virtually everything to lose from such a confrontation and virtually nothing to gain. By contrast, the US has much to gain in the long term and relatively little to lose in the short term from forcing the issue.Many pundits seem to think that China has an â??ace in the hole,â? which is that they could stop financing the US fiscal deficit. Nonsense. If the trade imbalance is eliminated, the Chinese will simply not have the foreign exchange resources available to finance the deficit. The funds currently being exported to China through the current account would essentially â??remain in the USâ? thereby increasing economic activity and the pool of resources in the US available to finance the deficit. Any transitional liquidity issues can be taken care of in a non-inflationary manner by Fed policies such as purchases of Treasury securities.The fact of the matter is that the US does not â??needâ? China. In fact, the current relationship with China is a major cause of current economic problems in the US. Thus, reframing the relationship with China has long-term upside for the US. From the content and tone of Bernankeâ??s speech, it is looking like US officials are starting to wake up to these facts and are adopting a stance toward China that makes a showdown increasingly inevitable, unless China preemptively backs down.Pursuant to my portfolio allocation strategy laid out in Global Tectonic Shifts Call for Portfolio Rebalancing, I am currently looking for an entry point to short iShares FTSE/Xinhua China 25 Index (FXI) and/or other securities exposed to Chinaâ??s equity markets. 2x inverse FTSE/Xinhua China 25 is another option that can be considered.
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