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The US Cat & China’s Yuan-Part II

( The first part was published in C3S paper no. 545 dated 22.7.10).

It was to the credit of the Bush administration, especially the Treasury under Hank Paulson, that it was aware of the deeper implications of U.S./China relations and did not see it only through the prism of the Yuan rate. It looked upon it as one necessary to deepen the relations between the two countries and, in particular, in the financial sector. In successive Strategic Economic Dialogue (SED) meetings, Paulson raised the issues in a composite way and gave as much importance to other issues.

On the exchange rate, he held the firm view that it was in China’s interest to have a flexible rate, a rate as close to market as practicable. He did not expect it to happen overnight. However, he pleaded with the Chinese to hasten the process having due regard to their concerns about social and economic stability.

The Currency Report issued on December 10, 2008, the last of the Bush administration reports, was advisory and not censorious. It referred to, “Persistently large current account surpluses, continued historically large interventions as evidenced by the rapid accumulation of foreign currency reserves, and a weak real effective exchange rate provide ample evidence that the renminbi is substantially undervalued.” It went on to urge China to rebalance its economy by relying more on domestic private consumption rather than on exports and by further deepening the financial markets. It concluded, “As a first step, the pace of appreciation in early 2008 needs to be resumed.” And Treasury will continue “to use every opportunity to impress upon Chinese authorities the importance and urgency of exchange rate reform.”

When this Report went out, the U.S. was under threat of one of the worst financial crises ever recorded in history. Needless to say, during the SED. Paulson had lost the high moral ground from which he could preach in the earlier meetings on exchange rates or financial markets. The sub-prime crisis which originated in the U.S. was engulfing the real economy and spreading globally. Unlike in the years of the earlier crises, say in Mexico, Argentina or East Asia, it was not confined to developing countries but dragged down the developed countries deeper into distress. (They are yet to recover from the trough, notwithstanding the hype of the western governments and pink papers about ‘green shoots’ and signs of higher growth, with the IMF as the lead piper!) The weak dollar began to play havoc with all other currencies in Europe and Asia. The U.S. could no longer blame the Chinese for creating financial imbalances.

In the SED, as Financial Times (December 19, 2007) reported, “Beijing turned the tables on the U.S. …. after years of criticism from Washington of its handling of the Chinese economy, warning of the serious implications of the weak dollar, recent U.S. interest rate cuts and the sub-prime crisis.”

Zhou Xiachuan, the Governor of the People’s Bank of China (PBoC), added, “For China, what we worry about more is that very accommodative U.S. monetary policy could give rise to a new burst of excess liquidity in global markets.” In the coming months, China’s worries would deepen and lead to a see-sawing of relations between the two. Developments in the financial markets would put to test the mutual trust which is so critical to ensure financial stability.

When the Obama administration took over early in 2009, it appeared to be unaware of the minefield it was stepping into. Timothy Geithner who took over as Treasury Secretary is young, but inexperienced in diplomacy. He was described as a technocrat who had grown up with the New York Fed and had a grip over Wall Street machinations. His exploits in handling the LTCM crisis a decade earlier, i.e. 1998, gave him the image of a wiz kid. What was not reckoned was that the Fed and the Treasury could no longer fight the current war with the strategy and weapons of the earlier war. It was a different world and the conditions had changed beyond recognition. Truly, it was a crisis whose dimensions and ramifications were not known. The jury is not yet out on the efforts made by the Geithner/Bernanke combine so far to fight the crisis and to lift the economy. Continuing low rate of growth, loss in manufacturing, mounting unemployment, depressed housing market, freeze in credit flows especially to small business, etc do not lend credence to their claims about early recovery. China along with many emerging economies was a victim for no fault on its part and was called upon to pay a heavy price.

In the early months of the Obama administration, its economic advisers appeared to be unmindful of the fears and sensitivities of China. What really led to the fear was the fact that in 2008 Obama had co-sponsored a legislation drafted by Senate Finance Committee Members – Debbie Stabenow and Jim Bunning- that would define currency manipulation as a subsidy under U.S. laws. Will the new administration carry the same baggage? Some of the statements made by the Treasury Secretary Timothy Geithner in the days prior to his confirmation fuelled the fears more. Most disturbing was his testimony to the Senate Committee on 21 January 2009.

One of the questions posed by the Committee was: “Does China manipulate its currency?” He replied, “President Obama- backed by the conclusions of a broad range of economists- believes that China is manipulating its currency. President Obama as President has pledged to use aggressively all the diplomatic avenues open to him to seek change in China’s currency practices.” Asked by Senator Jim Bunny whether he thought China’s ‘manipulation’ of its currency remained a serious problem, Geithner said, “I do believe it is a significant issue.”

These remarks reverberated not only in China but across the globe. Very soon, they were retracted as inappropriate and embarrassing. Sadly, the damage had been done and the administration and the Treasury had to work over-time for several months to remedy the hurt. And yet, as reports suggest, Geithner could not inspire the same degree of trust with the Chinese which Hank Paulson did. For all that, Geithner is said to be one of the officials knowing Mandarin having had a short stint at Peking University. He holds a Master’s degree in East Asian Studies. When he went to China on his first official visit in May 2009, “He shed his dress shoes for a pair of Nike sneakers to play basketball with the students at Renmin University High School in Beijing.” (Can Geithner Pull the Right Strings in U.S.-China Relations? Bloomberg Businessweek, April 25, 2010.) Even after such attempts at camaraderie, he does not seem to have established complete rapport with the Chinese. During discussions, he is reported to have quoted a Chinese proverb, feng yu tong zhou. It means ‘to stand together regardless of the situation.’ It did send the message that Geithner was willing to wait and allow his Chinese friends to take a longer view. Sadly, back home, he would be tormented by Senators and trade lobbies.

It was evident that China would not remain passive for long and continue to listen to U.S. bickering over the Yuan rate. With the onset of the crisis, there was a perceptible change in China’s stance. U.S. had to deal with a confident and newly invigorated China. As a New York Times report explained, China’s confident performance “underscored the growing financial and geopolitical importance of China, one of the few countries to retain enormous spending power despite slowing growth. It has the world’s largest reserves of foreign exchange, estimated at $2 trillion, the product of years of double-digit growth.” (China’s Leader says He is ‘Worried’ Over U.S. Treasuries, March 14, 2009.)

With the deepening of the crisis, China began to question the premises of the existing financial order. Undoubtedly, it was rooted in the creeping insecurity over the safety and value of dollar-denominated assets amounting to 60-70 per cent of its reserves. It started taking an aggressive stand and began to mount attacks on several fronts.

In the G-20 Meeting of November 2008, Prime Minister Wen Jibao pleaded for the adoption of different models of development depending on the level of development of countries. This was ignored. Even in the run up to the November G-20, the Americans were said to have ignored Wen and he would carry the grudge and demonstrate it in the later G-20 gatherings. In January 2009, he gave a speech criticizing what he called an “unsustainable model of development characterized by prolonged low savings and high consumption.” He did not refer to U.S. directly by name.

By March 2009, China’s stand hardened. In the run up to the G-20, Wen spoke in unusually blunt terms about the “safety” of China’s $1 trillion investments in American government debt, the world’s largest holding and urged Obama administration to offer assurances that the securities would maintain value. Though he did not directly criticize Washington’s policies, he reminded them of China’s status as its largest creditor. With mounting budget deficits and the continuing need to maintain stimulus, the U.S. had to finance the new debt at low interest rates. China was getting worried over its flip side. As Wen said, “President Obama and his new government have adopted a series of measures to deal with the financial crisis. We have expectations as to the effects of these measures,” Wen said. “We have lent a huge amount of money to the U.S. Of course, we are concerned about the safety of our assets. To be honest, I am definitely a little worried.”

By now it was evident that the two economies were intertwined like two pythons in a constricted cave and could not wriggle without the help of the other. China cannot save the value of its dollar-denominated assets without U.S. cooperation; and U.S. cannot continue with stimulus unless China was willing to invest in new debt. Without the stimulus, the U.S. economy will not recover, and China needed the U.S. recovery to maintain the level of its own exports. Again, dollar will collapse if China lost faith in dollar. Pink press covered these disputes in juicy narratives along with dire predictions, followed by denials, of the demise of the dollar.

There was painful realization of this mutual dependence and it led to restrained behavior or even bonhomie for a short while among the two. Analysts like Brzezinski sang about the emergence of G-2 or what Niall Ferguson called “Chimerica.” American authorities made special efforts to assure the Chinese that their assets were safe. Hillary Clinton was sent on a special mission to Beijing in June 2009 to give assurance about the safety of China’s holdings. She assured not only their safety but also pleaded with them to invest more. There were endless and continuing assurances of the safety of China’s. assets. During these months, it did not seem that the Yuan rate was a problem.

On 15 April 2009, the Treasury issued a Currency Report which was positive. It took note of several developments about exchange rate such as China taking steps to enhance exchange rate flexibility; actual appreciation of the currency by 16.6 percent; the slowing of rate of accumulation of reserves; and the stimulus package adopted by China to rebalance its economy. “Even, so, Treasury remains of the view that the renminbi is undervalued.” This was a sop to Senators!

By October 2009, the Treasury’s stand had hardened. This was perhaps based on the improvement in the U.S. economy and hopes of early recovery. The currency report of 15 October 2009 referred to the rigidity of renminbi and the reacceleration of reserves and felt these were serious concerns “which should be corrected to help ensure a stronger, more balanced global economy consistent with the G-20 Framework.” It added that the U.S. will continue to work with China both in the G-20 and bilateral Strategic and Economic Dialogue to pursue policies that permit greater flexibility of the exchange rate and lead to more sustainable balanced trade and growth.” Bringing in G-20 is a new addition or dimension! In later months, Geithner would keep on repeating that it is “China’s choice” to decide how and when to let market forces play a larger role in determining the Yuan’s rate.

What was intriguing about the currency report was that it tried to turn the table on the global imbalance wholly on China and laid all the blame on China for creating it through an undervalued Yuan! It ignored so many other factors and actors who contributed to it. Judged by facts, it was false and untenable. China had never accepted the charge in any forum or at any time. It had repeatedly hit back drawing attention to the reckless monetary policies of the Fed and the responsibility of the U.S. in creating imbalance through its own low savings, high debt and twin deficits.

It was evident that the U.S. was not playing ball and was harping on the Yuan rate as the root of all its evils. China was getting tired of such repeated attacks and beginning its counter strategies. At crucial moments, it came out with calculated threats or leaks that it would divest its dollar assets or shift them to other currencies. In the financial circles, this was dreaded as a ‘nuclear option.’ There would also be covert moves switching U.S. assets into euro. It is known that Treasury’s TIC data do not reveal all the holdings of China.

The Chinese are aware that the scope for divesting massive quantities of Treasuries or agency papers is limited. Detailed research has been done by several reputed economists and institutions, including the Congressional Research Service, on the damage or the scope for damage which China could inflict through these moves.

Many researchers had dismissed the threat as limited, unworkable and self destructive. However, as Prof. Easwar Prasad, a Senior Fellow of the Brookings and an old China specialist, explained in his testimony to the U.S.-China Economic and Security Review Commission (The U.S.-China economic relationship: Shifts and Twists in the Balance of Power, February 25, 2010), “Many analysts argue that any threat by China to shift a huge portion of its reserves out of U.S. government papers is just bluster as such a move would impose huge costs on China itself. But these costs tend to get overstated in popular discussion of the matter.” “In short, any Chinese threat to move aggressively out of Treasuries is a reasonably credible threat as the short term costs to the Chinese of such action are not likely to be large.” Moreover, under conditions of extreme volatility in currency markets, “a precipitous action by China to shift aggressively out U.S. dollar-denominated instruments, or even an announcement of such an action could act as a trigger that nervous market sentiments coalesce around, leading to a sharp fall in bond prices and the value of the U.S. dollar.” The Wall Street Journal (February 18, 2010) wrote about “Chinese whispers in Treasury mart” and how they operated from other locations like Hong Kong and the U.K. and through offshore intermediaries.

Whatever might have been the past behaviour or strategies of the Chinese, there is evidence that, in recent years, they have shown restraint and acted as responsible stakeholders. Rather, they are as much worried about the safety of their assets and the impact of their operations on currency markets as the Treasury or other central banks. When euro was in crisis beginning with the second quarter of this year, they cooperated with the U.S. Treasury to safeguard it value. China too held substantial holdings in euro could not afford to see them collapse. As we saw in Part-I earlier, they began to move back to dollar as a safety blanket even with lower returns.

China had acquired those euro assets in 2008 in large value running to billions. Though there is no official record or proof, perhaps, Geithner’s unscheduled meeting with the Chinese Vice Premier Wang Qishan for a few hours on April 8, 2010 at the Beijing airport on his way from India to Washington was to bring this about. Of course, the officially stated purpose was to discuss the Yuan issue. It would indeed have been discussed and led to the Treasury decision to postpone the Currency Report due on 15 April 2010. It was to return the courtesy!

In spite of all the limitations attached to the currency market, China could have played the cat and mouse game with the U.S. in the currency market. There are grounds to believe that China did not engage indiscriminately in the market with U.S. Treasuries or agency papers. This was as much due to its concern to maintain good relations with the U.S. as to its concern over the long-term safety and value of its assets. Sadly, U.S. did not reciprocate in equal measure and was succumbing repeatedly to Senators and trade lobbies. China began to seek alternative measures.

China had commenced its efforts to de-dollarise the Yuan a few years, i.e. long before the onset of the crisis. Its move undertaken in 2005 to peg the Yuan to a basket of currencies was the earliest and most radical step. Even earlier, it was associated with Asian countries in the work leading to the creation of new safety nets for the Asian economy. This was in the nature of regional self-insurance and to move away from its dependence on the IMF. It cooperated with ASEAN in particular for the creation and enlargement of the Chiang Mai Initiative (CMI). Along side, it started working on a strategy of offering swaps to partner countries to enlarge trade and settle payments in Yuan. These small steps signaled that China was working on a long-term strategy to dislodge the hegemonic role of the U.S. dollar as a reserve currency.

Zhou Xiachuan of the PBoC unveiled the proposal to introduce a new reserve currency in replacement of the U.S. dollar. This was in a speech delivered on 23 March 2009 in the lead up to the G-20 London Summit. It was titled “Reflections on Reforming the International Monetary System.” He asked what “kind of international reserve currency we need to secure global financial stability and facilitate world economic growth?,” and answered that the world needs an international currency option “that is disconnected to individual nations and is able to remain stable in the long run, thus removing the inherent deficiencies caused by using credit-based national currencies.” He did not spell out the details of the scheme, but had only set out the broad contours. He argued that the world needed a new and better reserve currency, one not dominated by a single country and it was in the interest of the world that the reserve currency be created by a body like the IMF. He was hoping for larger role for the SDRs in the system.

The ideas of Dr. Zhou disturbed the dovecotes in western governments and financial circles. Economists like Joseph Stiglitz welcomed it immediately. Even the U.S. Treasury did not oppose it, in spite of the initial faux pas committed by Obama in rejecting it. It is difficult to deal at length with all the issues raised in the speech of Dr. Zhou’s scheme.

Soon after this speech, there were global debates on the viability of introducing a new reserve currency, especially SDR. In a long and clinically analysed paper, Professors Gregory Chin and Wang Yong, throw light on the aims and expectations of Chinese authorities and the debates which have been going on with within China among PBoC, Treasury officials and the academic thinkers which had given rise to that proposal. (“Debating the International Currency System: What is in a Speech?” China Security, Vol.6 No.1, 2010, pp.3-20.) As the two authors say, the speech marks for the first time a high profile statement publicly issued by the Chinese leadership expressing concern about the International Currency System (ICS). It is also the “first indication that China is seriously reconsidering its reliance on the dollar and is beginning to cultivate options for reducing its international monetary dependence on the United States.”

China has taken several steps to distance itself from the dollar and to internatinalise the role of the Yuan. It has currency swap agreements worth $95 billion with Indonesia, South Korea, Hong Kong, Malaysia, Belarus and Argentina. Very recently it has entered into agreement with Singapore. It has agreement with Brazil and Russia to encourage trade settlement in each other’s currencies. On a trial basis it allows a group of export firms in Guangdong and Shanghai to settle trade in Yuan. It has permitted “net settlement system” to increase liquidity and trading volume in domestic inter-currency market. It has permitted select banks in Hong Kong to issue Yuan-denominated bonds. China has increased substantially its holding in gold and its efforts to step up stocks are constrained by the price impact of its purchases in the global markets. China has stepped its investments in Africa and Latin America to forge trading relations and to feed the mills back home. Its attempts to use sovereign wealth funds to make large value investments in the west are well known and some of them have been rejected on political grounds. China has also shown willingness to invest in SDRs but will go so only if the management structure of the IMF is changed. All these are steps to diversify its reserves and to move away from dollar. They may lead over time to the internationalization of the Yuan as well.

However, among China’s policymakers there is no illusion that dollar would cease to be reserve currency in the near future. Nor do they hope that the Yuan would become internatioalised in the next 10 or 15 years. But they would gradually move towards it and take necessary steps. However, as the two authors go on to explain, it signals a more confident and forceful China “which has been emboldened by its performance amid global depression and is no longer willing to stand back from the global spotlight and limit itself to expressing concerns behind closed doors.”

Dr. Zhou’s speech indirectly put the new U.S. administration on “the defensive about future currency and global macro-coordination priorities.” China’s scholars and analysts seem to suggest that the SDR proposal was a short-term diplomatic maneuver to gain leverage at the G-20 and G-8 meetings and “Beijing has now dropped it after largely achieving the intended results.” One major gain was that the Yuan issue was not taken up at any of the G-20 meetings though Currency Reports say “it will be resolved within the G-20 framework!”

One would have thought that the understandings reached in SED, G-20 and other official meetings would have given a quietus to the Yuan dispute. Like cats, it has nine lives. It comes back again and again and Senators and U.S. lobbies cannot survive politically without keeping it alive.

In the early months of 2010 the debate turned strident with the continuing economic depression, fall in manufacturing and, more importantly, the rise in unemployment and no signs of growth. With unemployment crossing 10 percent, Congress was said to be losing patience with China’s arguments. Senators began to file Bills seeking to impose tariffs on Chinese imports. “We’re fed up,” Mr. Schumer said. “China’s mercantilist policies are hurting the rest of the world, not just America. It helped create the global recession we are in. The Chinese want to be treated as a developing country, but they are global giant, the leading exporter of the world.” “The only thing that will make China move is tough legislation,” Mr. Schumer said.

On March 15, 2010, 130 Democratic and Republican lawmakers called U.S. Treasury Secretary to brand China a currency manipulator in report due in mid April saying Beijing was in effect subsidizing exports. They recommended anti-dumping duties against Chinese imports and taking up the matter with the W.T.O. The Treasury tried to assuage their fears and referred to the ongoing dialogues with China and its assurance to appreciate the Yuan flexibly.

Many academicians of repute joined the debate and began to recommend that the U.S. should not treat the issue unilaterally and make it multilateral as it hurts the trading interests of others. Fred Bergsten of the Brooking had taken the lead long before. Easwar was one of them. Others like Arvind Subramanian also developed new arguments. It was rather shocking that Prof. Paul Krugman, the respected Nobel Laureate, would be one of them. In a New York Times op-ed piece, Krugman squarely blamed China for the rising unemployment in the U.S. and estimated it at 1.5 million. He made other jibes at China’s Treasury holdings. These economists were mixing up the consequences of globalization such as relocation of industries, shrinkage in employment, etc are better related to the strategies of multinational corporations than to the role of currency rate. “China price” consists of several constituents and exchange rate plays a small part. As some economists have suggested, in non-market economies (as China is being treated in the WTO) non-tradable items have tremendous cost advantage vis-à-vis market economies.

The broad strategy provided by these economists was as under:

1. Declare China as a manipulator of currency.

2. Refer the issue to the IMF and assess the element of ‘subsidy’

resulting from manipulation.

3. File a complaint with the WTO and charge punitive duties.

The game plan was alluring and ready for action. Declare China as the Currency Manipulator in the next Currency Report due on 15 April 2010 and the rest will fall in place.

Thus it was that the Currency report due in April 2010 assumed undue importance and so much of dance and drama was played over it. The U.S. had not reckoned that its major policies, especially with China are mixed with other policies of global significance such as on nuclear weapons, Iran sanctions, North Korea, and others. In April, Wen decided to attend the nuclear meeting in Washington and it was received with great excitement. As a trade off, U.S. President rang up Treasury Secretary to postpone the Report. As explained earlier, it had also been agreed in the discussions with Vice Premier Wang Qiahang. Though Treasury Secretary decided to postpone the Report, he took cover under the face saving announcement that it would be pursued within the framework of the G-20. China also gained reprieve when the euro crisis broke up and upset the currency market.

Even as time was gained by this postponement, there were rumours and reports from China that it was engaged in a serious exercise over greater flexibility for the Yuan. China Security paper referred to earlier provides more details on this. Around this time, Zhou also made the quizzical announcement that China would revert back to the flexibility announced in 2005. He clarified that the freeze imposed in 2008 after the crisis was a temporary measure to tide the financial interests and would be rescinded once there are signs of recovery.

The next G-20 was due in Toronto and there was no hope of any great achievement in the meeting. However, the U.S. was keener than others to cling to it, more to save its own stimulus and to ensure that others would not upset the apple cart. The Yuan rate issue could not have been raised if any one had followed or understood China’s posture and psychology all along.

China surprised the world by making the announcement that it would float the Yuan with reference to a basket of currencies. The spread was fixed at 0.5 percent both ways. This was greeting with relief and global approbation. All that China had done was to reintroduce the system which it had brought about in 2005 and stopped as a temporary measure. The U.S. was cautious in welcoming the move and said that it would wait and watch the rate of appreciation

Since then, the Deputy Governor of the PBoc has issued three more statements elaborating the rationale and how the system of currency management would operate. These take into account several views or critique offered over the years by economists and development theorists to make the Yuan rate operate in a more realistic manner ensuring domestic equity and, internationally, market friendly. There can be no quarrel over it for the present. However, surprisingly, Senator Hoyer has said that there would be a Senate meeting in September to review China’s Yuan rate.

In Toronto, much to the chagrin of the Americans, the issue did not come up. It was not because China had announced its flexibility a week earlier. It was assessed that no developing country in the G-20 would have supported the U.S. measure. China has become such an integral force in their trading and currency relations that they would not let down China. It was significant that though an effort was made to refer to the issue and praise China, China did not want any inclusion. So much for U.S. reliance on G-20!

The U.S. strategy narrated above has fallen on its face for another major development. On July 26, 2010, the IMF Executive Board concluded Article IV consultation with China. (( The assessment made by the IMF staff came for review by the Board and the Board did not agree with the staff assessment. As Financial Times reported, “Several directors agreed that the exchange rate is uyndervalue3d, a number of others disagreed with the staff’s assessment of the level of the exchange rate, noting that it is based on uncertain forecasts of the current account surplus.” There was a clear divide between developed country members (U.S., Germany, France and the U.K.) and the developing countries. The Board seems to have been influenced by the clarifications issued by the PBoC. The Board has gone out of its way to praise the efforts made by China in fighting the financial crisis and also helping global efforts in that behalf. “Directors commended the Chinese authorities for their commitment to the G-20 framework for strong, sustainable, and balanced growth.”

The U.S. Treasury has issued 44 Currency Reports till date and except in 1994, it did not express any reservation over the Yuan rate. The cause for action, if at all, would flow only if the Treasury takes the IMF along. If the IMF does not agree, there can be no complaints to the WTO or any other agency for punitive action.

The U.S. cat has thus far failed to catch China’s mouse. Hopefully it will not chase it in the coming years. As years go by, the Cat gets weaker even as global economic balance shifts and China’s mouse gets stronger and becomes more agile.

(The Writer, Mr K.Subramanian, is a retired Joint Secretary (finance) in the Govt of India. He is presently associate of the Chennai Centre for China Studies. Email:

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