The US and China are currently unable to reach a compromise on the dispute over the Yuan's strength against the US dollar. The US President could succumb to domestic political pressure and introduce measures to protect jobs, resulting in increased tariffs on Chinese imports.
As per ICIS, in 1971, as Paul Krugman pointed out that emergency import tariffs of 10% were placed on Japan and Germany because of a similar row over the strength of their currencies. He believes a 25% tariff should be imposed on Chinese imports. He argues that China's huge holding of Treasury Bills is in America's favour rather than the other way round, which is the conventional view. Any sudden liquidation of these reserves would drive the value of US government bonds down, thereby reducing China's financial strength, while at the same time pushing down the value of the greenback. This would make it easier for the US to export its way to recovery (provided, of course, there isn't the very likely response of trade barriers springing up around the world).
The weakness in Krugman's argument is with regard to the effect on migrant workers in China's export processing zones and what this would mean for the global economy. A tariff of anywhere close to 25% would leave millions of these migrants of work, creating huge social and political pressure. Offshore trading contracts are now anticipating a 2.4% rise in the value of China's currency later this year. Financial analysts expect the Yuan's value to increase by between 2-5% during each of the next few years as the main focus in China is on protecting growth rather than controlling inflation. This might not be enough for the US as they are in the midst of a jobless recovery. During the 2004-7 boom period it didn't matter that employment was drifting to China because consumer credit was abundant and jobs in the US were being created in sectors such as housing.Currently, while the US was enjoying a V-shaped rebound, the weak consumer sector and continued high unemployment will constrain the strength of the recovery.
With significant declines in household wealth over the past two years, consumers are working to pay down debt and have become cautious in their spending. Big US retailers are reportedly squeezing more costs out of procurement in order to meet the needs of this more cautious US consumer. The retailers appear to be getting a lot of help from Chinese manufacturers thanks to the undervalued Yuan and the re-imposition of export tax subsidies. In other words, China is in a stronger position to export lower-priced goods and by so doing, drive US unemployment even higher.
Further adding to the deflationary impetus is that a big quantity of China's huge economic stimulus seems to have gone into fixed asset investment. Big state-owned enterprises received a flood of soft loans from the state-owned banks, perhaps under the assumption that - because both the banks and companies are owned by the government - foreclosure was unlikely if investments failed. The strong import volumes seen for a wide range of chemicals and polymers in 2009 were partly the result of this rise in fixed-asset investments. Western chemicals companies benefited from this inventory building. For example, US Linear-Low Density Polyethylene (LLDPE) exports to China rose to 318,369 tons in 2009 from 183, 293 tons in 2008, according to data from China Customs, while polypropylene (PP) exports rose to 493, 381 tons from 117,673 tons. But the irony is that as they made export gains, Western chemicals companies could have been further undermining their domestic manufacturing industries through migrating more jobs to China, as we pointed out last week.
If the value of the Yuan is increased, even by only a few percentage points a year, lower-value manufacturing in China such as textiles and garments, will suffer. Margins at this end of manufacturing in China are razor-thin and therefore dependent on today's currency advantage. This is another reason to believe that a repeat of last year's extraordinary chemicals and polymer import volumes is unlikely.