Let the ‘Trade Wars’ end!?!

According to a recent article by Charles Wallace, posted on the Daily Finance (Currency Wars: How Ben Bernanke Outsmarted China), the U.S. has already taken the first ‘shot’ of the U.S.-China – often proclaimed, never materializing – trade war.

Mr. Wallace reported that Fed Chairman Ben Bernanke’s program of quantitative easing is targeting the Chinese currency and causing inflation in China.  In particular:

Last fall, he (Ben Bernanke) announced a program of quantitative easing — a federal bond-buying program — which was targeted, he said, at raising U.S. inflation to head off possible deflation.

But in reality, it had a completely different result: Money poured out of the U.S. and flowed into China. According to Adam Wolfe, research analyst at Roubini Global Economics, the amount of so-called hot money entering China reached $1 billion a month in 2010.

Coming on top of China’s massive trade surplus, those inflows presented a dilemma for the Bank of China. In order to maintain its exchange rate with the U.S. dollar, which was fixed after 2008, the Chinese government bought dollars from exporters and banks and printed local yuan for each dollar it purchased.

But last fall, the supply of yuan skyrocketed, increasing by 19.7% in December, Wolfe says. Increasing the money supply causes prices to increase as more money chases fewer products. Chinese inflation had ramped up 4.9% in November, compared with the same month in 2009.

As we saw last fall, China tried to slow-down inflation (the rise of prices) last fall by twice raising interest rates.  With fourth quarter GDP figures showing that the Chinese economy grew by 9.8% it is fair to agree with Mr. Wallace that the Chinese government has failed in cooling down the economy.  Mr. Wallace reports that there are two available options left for the Chinese to limit prices:

Impose price controls or raise the value of the yuan, which reduces the price of imports. Price controls rarely work for more than a short time because people find ways around them, such as the black market.

It now seems likely the Chinese will opt for raising the yuan’s value. Since last June, the currency has appreciated about 3.5%, or an annual rate of about 7%. When you add inflation, that’s 12%. Wolfe says he expects the same level of appreciation for 2011, while Rickards says he sees the yuan rising by at least 10%.

The proposition that the Chairman of the US Federal Reserve has targeted the Chinese currency with his quantitative easing policy is very possible, considering that even the President of China believes so, and has said so right before his recent trip to Washington, DC.  It is also no secret that the one economic development that the Chinese authorities fear the most is inflation.

However, I am not convinced that it is the U.S. quantitative easing that is causing inflation in China.  What I am convinced however is that the Chinese government is prone to instinctive behavior, rather than calculated action.  It is their instinct to buy U.S. debt, no matter what.  No they might be realizing that the system they created (capitol controls and a fixed currency exchange) is causing the very inflation they fear the most.

Never the less, if this article is correct, then the Fed’s quantitative easing could prove to be the one and only act of this U.S-China trade war.  The impending inflation in China could force it to adopt the kind of currency/export/consumption policies that the West has been asking since it joined the WTO.  Raising the value of the RMB at this point, right after the Chinese President met with the U.S. President who repeatedly asked for faster appreciation of the RMB, could also be beneficial for China.

Allowing the RMB to appreciate faster than in has in the past 6 months, could address both inflationary pressures domestically, and appease the U.S. government internationally… thus turning a ‘crisis into an opportunity’ (again), and averting a damaging (to the whole world) trade war between the U.S. and China.