The debate over the future of China's currency regime continues to rumble on ahead of the US Treasury's pending decision on whether to declare China a currency manipulator. There are three basic scenarios:
1. Currency Kabuki
Washington and Beijing continue their now almost-ritualised disagreement over the value of the yuan. Both sides play the game with an eye to domestic politics: Washington shows it cares about the complaints it receives about 'unfair' Chinese competition and deflationary policies, and Beijing shows it can stand up to foreign 'bullying'. Otherwise, nothing much happens.
In the near-term, this does not look like too bad an outcome. But it would leave both the world and Chinese economies still dealing with the economic consequences of a misaligned exchange rate. Moreover, the disagreement over the currency would continue to drip its poison into the international economic environment.
2. Back To The Future
We essentially get a re-run of 2005, whereby Beijing decides that it is both in its domestic interests to adjust its exchange rate regime and that there are international policy benefits to doing so. The first step would probably be some modest down payment on currency adjustment (for example, in July 2005, Beijing delivered a small 2.1% appreciation of the RMB against the dollar), followed by further, measured progress (between July 2005 and July 2008 the RMB was allowed to appreciate by almost 19% before it was effectively re-pegged).
This is the best-case scenario, since both China and the rest of the world get a Chinese exchange rate that is more closely aligned to the underlying economic fundamentals.
3. Trade War
Both sides refuse to back down, a frustrated US turns to aggressive trade measures and Beijing responds with trade measures of its own. This is the worst-case scenario.
I have tended to think that some combination of the first two scenarios is the most likely. That is, both sides will play Currency Kabuki for a while, but we'll eventually end up with a similar kind of compromise to the one we got in 2005.
This outcome is actually in the interests of both sides. There are good domestic reasons for China to adjust its exchange rate, given that current macro policy settings look increasingly inappropriate. Indeed, many – although certainly not all – voices in China agree. Furthermore, neither side would benefit from a trade war. I continue to think this is the most likely outcome, and even in the heat of the current debate there are signs of compromise to be found.
That said, my worry is that the probability of option 3, which I used to think was very low, has started to rise. In large part, this seems to reflect the quite different environment in the US and China prevailing in the aftermath of the GFC.
In the case of the US, a much weaker economy, a significantly higher rate of unemployment and an increased sense of economic vulnerability all point to a reduced tolerance for another round of Currency Kabuki. A telling indicator of this shift is a reported decline in the willingness of China's erstwhile defenders in the US corporate sector to step up to the plate this time. Other parts of the world may be losing patience too, albeit more slowly.
The China story is almost the mirror image of this one. China's strong economic performance in the aftermath of the Great Recession, together with recent policy failures in the US, have produced a parallel decline in Chinese tolerance for lectures on economic policy, particularly from a country that has just so decisively bungled its own economic management.
Even before this latest currency row there were some signs of a sort-of trade 'cold war' between the two economies. The last thing the world needs is for this cold war to turn hot. It would be a nasty irony indeed if, having got through the worst of the GFC and congratulated ourselves on learning the lessons of history by refraining from the kind of protectionist responses that scarred the 1930s, the world ended up heading down the Smoot-Hawley route after all.
Photo by Flickr user sminamijp, used under a Creative Commons license.