Tuesday, September 28, 2010

Trade War with China Looms

My modest suggestion if we were to have a trade war is not to slap any tariffs on their products - that would violate the WTO agreement. Instead devise a tax on the purchase of treasuries or other US government bonds made by foreign central banks, government institutions etc. The way China keeps its currency low is not just through controlling the exchange rate, but by using all the US dollar funds from exports to buy US financial instruments to "sterilize" their trade surplus from causing a strengthening of their currency.

This would also affect Japan, Taiwan, and Korea who also play the sterilization game to some extent or another. This is important not just because they too should not be manipulating their currencies so much, but also because China has in the past bought Yen with their US dollars. This made the Yen strong which forced Japan to step in and do China's work for them, so to speak.

Now, China could buy private bonds, but those have default risk, which makes their game far more riskier. Also, I am not sure they could find enough bonds to purchase. I would also explicitly remove US government backing from Fannie and Freddie bonds. Let China take some risk of losing money on their US dollar holdings. One reason China is afraid to allow their currency to appreciate normally, is because their mountain of US treasuries and bonds will immediately lose value. Well, adding some risk on the other side might make it more palatable for China to change their position. Personally, I think we should have given them a haircut on their Fannie and Freddie holdings back during the crisis instead of making them whole.

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