China’s Currency Manipulation: About to Cause a Global Explosion?

Tim Geithner, Hillary Clinton and 200 other American bigwigs visited China this week.

First on the agenda: China’s position on the rising tensions between North and South Korea.

With the rest of the major economic powers of the world standing against the actions of North Korea — a nuclear threat run by an oppressive regime — a neutral standing China poses a reasonable concern for future global stability.

Another significant topic Geithner was hoping to make headway on was China’s currency policy. But China had little to say on the matter.

China’s currency continues to be a subject the U.S. is willing to tap dance around diplomatically. Because when the gloves eventually do come off, U.S./China relations could rapidly collapse.

That’s why China’s alignment on the Korean peninsula tensions is of particular significance …

It puts the catalysts in place for potential fallout between China and the Western world, which could mean economic war and perhaps military war ahead.

Despite the smile, Geithner couldn’t get the Chinese to say much about their currency policies.

I think China’s currency policy represents too big a risk to global economic recovery and global stability for Washington to continue granting a stay. So today I want to revisit two of the arguments I’ve laid out in past Money and Markets columns to explain why we should worry about China, despite the headlines about it being an engine of global growth.

The first is …

China’s Currency Manipulation Poses a Roadblock to Sustainable Global Economic Growth

The G-20, the IMF, the OECD — all of the major institutions and central banks of the world have been harping on the importance of repairing global imbalances over the past year … and for good reason. When they do this, they’re talking specifically to China.

Over the last 14 years, China’s economy has grown a whopping eight-fold, to $4.9 trillion, and it has quickly soared to become the world’s third-largest economy.

During the same period, the U.S. economy has only doubled in size.

As far as currencies are concerned, the dramatic outperformance of the Chinese economy relative to the U.S. economy would normally be reflected in a much stronger Chinese currency.

But China controls the value of its currency. They allowed it to strengthen only 18 percent during those 14 years — a mere drop in the bucket, keeping the advantage squarely in China’s court.

Moreover, since the financial crisis and global recession kicked in two years ago, China has returned to a peg against the dollar, artificially keeping its goods cheap for a weaker U.S. consumer and undercutting its export-centric competitors.

As long as China continues to control its currency, global trade will remain lopsided.

Here’s the problem: The global trade imbalance driven by China’s cheap currency is a recipe for more frequent boom and bust cycles. So this issue has to be addressed.

Then there is the …

Threat of Protectionism

Ultimately, the rest of the world will have to choose action over diplomacy. That means imposing sanctions on China and trade restrictions on Chinese goods.

But the problem with protectionist activity is that it tends to bring about retaliation, and it becomes contagious. That’s exactly what happened in the Great Depression. And it’s what brought global trade to a standstill.

Today, with unemployment sustaining high levels, the political support to act is there. Many would think that “standing up to China, is standing up for us.”

You see, when jobs are tight the perception by most workers towards globalization becomes more negative. And studies show that during these times, the number of people who favor the idea of higher tariffs on imported goods increases considerably. As it becomes increasingly evident that China will not play ball on allowing its currency to appreciate to a fair value, geopolitical tensions are bound to elevate, and protectionism will likely follow.

And given the sovereign debt crisis that’s already underway, protectionism is yet another risk to the global economy that increases the probability of another bout with recession.

In fact, protectionism has historically put fragile economies in a deeper and more prolonged crisis …

I want to show you a chart of the S&P 500 from the Great Depression years. This gives you a clear understanding of why protectionism is so dangerous.

As you can see, the stock market topped in 1929 and fell 45 percent in just three months. Then, it had a sharp correction, recovering 47 percent from the November ‘29 low.

In June 1930, two U.S. Congressmen, Smoot and Hawley, championed a bill to slap a tariff on virtually every foreign good. And that was the catalyst for the second leg down … a massive plunge in the stock market and arguably the catalyst for the Great Depression.

Since April 15, Treasury Secretary Geithner has been “on the clock.” He’s past due on a currency report he owes Congress. In it he is expected, under recently adopted more stringent rules, to publicly name China a currency manipulator. And with that, a can of worms would be opened.

As an investor, it’s always important that you anticipate plausible scenarios. Because if a China conflict scenario plays out, you can expect the outcome to be bad for global growth, bad for global stocks, bad for commodity demand and likely good for the continued safe haven appeal of the U.S. dollar.

Regards,

Bryan