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The Chinese government, in an effort to maximize exports and minimize US imports prints their yuan to buy dollars. This prevents their currency from rising and the dollar from falling. Then it loans those same dollars back to America by buying US debt.

At the same time China:

• Puts in place purchasing restrictions
• Permits piracy
• Delays legitimate items from entering the country
• Provides massive direct subsidization of export production in many key industries
• Maintains strict non-tariff barriers to imports

In 2009 U.S. imports from China were worth $296.4 billion. U.S. exports to China equaled $69.5 billion. In the first half of 2010 the U.S. trade gap with China equaled $119.5 billion.

The American Congress is facing a restless, very concerned, and increasingly vocal American public. Lawmakers in both the Senate and House, responding to voters unhappy with high unemployment - 25 million people don't have a job or are working part time, 6.2 million people have been out of work for longer than 6 months - are blaming China for the loss of US jobs and are pushing for legislation that would expand the government's power to impose trade sanctions on China.

With midterm elections in November and the Obama Administration vulnerable in the House and Senate there's the very real possibility that President Obama will pass a law that restricts Chinese exports into the US - Obama did promise to get tough on China over its currency practices in his election campaign and he is now facing bipartisan pressure.

Many economists, and most US manufacturers, estimate China's currency is undervalued by up to 40 percent. An undervalued yuan means that Chinese products are cheaper for U.S. consumers but American products cost more for Chinese consumers.

Treasury Secretary Timothy Geithner, while not yet endorsing the new legislation, said China must move faster to allow its currency to rise in value against the dollar. Recently China's central bank did allow (the yuan's trading range is controlled by the Chinese government) the yuan to rise against the US dollar. But with only just a 1.6 percent rise since June many lawmakers in the US are frustrated.

The US Treasury is required to submit to Congress twice a year (April and October) a report Congress can use to identify whether any of the US's major trade partners have manipulated their currencies to boost their exports to the US or make U.S. goods more expensive in their markets. Will the US declare China a Currency Manipulator this October?

"We will take China's actions into account as we prepare the next Foreign Exchange Report (due on Oct. 15) and we are examining the important questions of what mix of tools ... might help the Chinese authorities to move more quickly." US Treasury Secretary Timothy Geithner

If China is designated a currency manipulator it could lead to economic sanctions if the U.S. took a case before the World Trade Organization (WTO) and won.

The Obama administration recently filed two new trade cases against China before the Geneva-based WTO.

"We are concerned that China is breaking its trade commitments to the United States and other WTO partners." U.S. Trade Representative Ron Kirk

China's Problems

Capital controls and trade restrictions have been absolutely necessary for China to reach this stage in its economic development. The country's economic development is largely driven by fixed asset investments (FAI - fixed assets include items such as land and buildings, motor vehicles, and plant and machinery). China's fixed assets investment reached 14.1 trillion yuan (2.1 trillion U.S. dollars) in the first eight months of 2010.

China is able to invest so much into FAI because, in addition to the inflow of foreign direct investment (FDI equaled 488.7 billion yuan in the first eight months of the year, FDI is a measure of foreign ownership of productive assets, such as factories, mines and land) its citizens have a very high savings rate as a percentage of income. And because of controls on how and where they can invest that money, Chinese savers have little choice but to invest at home. If China were to lift its capital controls the resulting outward savings flow seeking higher and safer returns overseas would cause China's economic growth to stall because the largest by far of its two major engines of growth, FAI, would simply run out of money.

Before he was forced onto the Bush/Snow party bandwagon former Federal Reserve Chairman Alan Greenspan said a floating exchange rate and/or ending capital controls could trigger an outward flood of capital to more secure foreign banks (Chinese banks, still to this day, carry a massive amount of bad loans). He went on to say this might destabilize the Chinese economy and drag down world growth.

"Export industries employ so many people, and a drop in exports would mean a rise in unemployment which could cause very serious social unrest. Social stability is Chinese leaders' top priority, and the way to achieve it is fast economic growth to keep people working." Xiang Songzuo, deputy head of the International Monetary Institute at Beijing's Renmin University

The Chinese Communist leaders have to feed, cloth and house untold millions of urban residents and hundreds of millions more rural residents moving to urban areas over the next couple of decades. Their biggest fear is social unrest leading to an overthrow of their communist regime. US lawmakers on the other hand are facing midterm elections and nothing is more important to a politician than getting reelected, jobs are the hot button of these midterms and the Obama Administration is vulnerable.

Japan increased its holdings of US Treasury Bonds by $16.9 billion in June alone. Demand for Treasuries from U.S. investors is increasing at a tremendous pace. Spending and incomes are stagnating and the savings rate hit the highest level in almost 18 years reaching 6.4 percent in June said the Commerce Department on Aug. 3 - the U.S. savings rate has now been higher than 5 percent for 21 straight months.

The bottom line here is China's buying of US debt might not have the importance it use to.

"Americans are consuming less and saving more. That causes an increase in savings and deposits, which end up being invested in government securities." Jeffrey Caughron, the chief market analyst in Oklahoma City at Baker Group,

The US could put in place their own capital controls. Washington could also 100 percent shut down the US market to Chinese exports. A major clash would bloody both nations but in the end China would lose the most and the politburo would run an even greater risk of losing its position of power than in a loosening of capital controls.

This dispute over Chinese currency reevaluation is just the harbinger, the tip of the iceburg, of what's to come in the future US-China relationship. Potential areas of conflict include:

• Trade disputes
• Conflicts over resources
• Geopolitical disagreements
• Intellectual property rights
• Chinese acquisition of US companies

This is an extremely interesting drama being played out on the world stage between two of the world's most powerful nations and economies. It's a powerful story unfolding in real time and it should be on everyone's radar screen. It certainly is on mine.

Is it on yours?

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