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The Risks of Getting Tough with China

By David Ethridge As the World Trade Organization meets in Cancun, Mexico, frustration continues to mount among U.S. lawmakers about China's "weak yuan" strategy (see BW Online, 8/28/03, "A Travel Alert for John Snow"). Their beef: Beijing is keeping the value of its currency, the yuan, artificially low to boost exports.

Now, that frustration may be giving way to concrete action. On Sept. 9, a bipartisan group of U.S. legislators, led by Sen. Charles Schumer (D-N.Y.) and Sen. Lindsey Graham (R-S.C.) introduced legislation that would impose a 27.5% tariff on Chinese imports, should Beijing fail to loosen or end its foreign-exchange peg to the U.S. dollar.

DECREASED BOND PURCHASES. The possibility of such a bill becoming law is no slam dunk, especially since it might be illegal under WTO bylaws. However, it is the most concrete example to date of Congressional anger at cheap Asian imports -- and what lawmakers see as "manipulative" foreign-exchange policies -- that are hurting the U.S. manufacturing sector. The issue figures to grow in importance as the 2004 election campaign kicks into high gear.

The bill's sponsors plan to pass a "Sense of the Senate" resolution condemning China's currency policy. That could spark reaction in foreign-exchange markets at the expense of the dollar, since it might be seen as a move by Uncle Sam toward a protectionist stance -- like the Bush Administration's imposition of steel tariffs in 2002 and the trade politics surrounding Japan's ascendancy as an export power in the 1980s.

As for the Middle Kingdom, expect finance officials to bend somewhat on this controversial issue. Market players have been speculating that China will widen the trading band for the yuan vs. the greenback a bit, at the very least, over the next 12 months. But it will come on Beijing's terms, not Washington's. This driving factor will be China's long-term forex and economic-policy goals, rather than a response to U.S. government pressure.

THE DOWNSIDE. Of course, any move by China to strengthen the yuan could have effects beyond the export arena. China has been a major purchaser (along with other Asian central banks) of U.S. Treasury and agency debt to help keep its currency at its desired level against the dollar. As such, it plays a key role in funding the ever-swelling U.S. trade and current account deficits.

Any decision by Beijing and other Asian economic powers to cut back on their U.S. government debt purchases leaves the Treasury market at potential risk. With a stronger currency peg vs. the dollar, China would purchase fewer bonds, as would Asian central banks if they were to cut back on currency market intervention (buying up U.S. debt to help prop up their own currencies).

And further weakness in the Treasury market, with a resulting bump higher in interest rates, could weigh on the long-gestating U.S. recovery. In that regard, U.S. lawmakers should be very careful what they wish for. Ethridge is a senior market strategist for MMS International

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