The first move by the Obama economic team in the delicate area of international economic and financial relations is a serious misstep, in our view.  The counterparts in China to Treasury Secretary designee Tim Geithner and the head of the National Economic Council, Larry Summers, were confronted at the end of last week with the following statement (repeated twice) in a written submission by Geithner to the US Senate Finance Committee:

“President Obama – backed by the conclusions of a broad range of economists – believes that China is manipulating its currency. President Obama has pledged as President to use aggressively all the diplomatic avenues open to him to seek change in China's currency practices.”

This statement takes an issue central to the US – Chinese commercial and financial relations, which have been handled with considerable finesse by former Treasury Secretary Paulson – and moves it from thoughtful consultations to “aggressive diplomacy”, in other words, confrontation.

The Chinese are familiar, from the Clinton era, with the blunt, undiplomatic style of Larry Summers but probably still were surprised to receive this shot across their bow in the opening days of the Obama Presidency.  While this may play well among the more protectionist-leaning politicians in the US, it risks seriously undermining our relations with a major trading and investment partner at a critical time for our economy.  It is ironic, as well as disturbing, that an administration that has the stated intention to move the US from a confrontational approach to more effective diplomacy in the foreign policy arena should veer off in the opposite direction in international economic relations.

There is no debating the fact that China has a managed exchange rate.  China’s fears about moving all the way to a freely floating currency are not without some merit. The Chinese financial and regulatory system still is not up to advanced-economy standards.  The consultations between China and the US on this issue have focused, rather, on the (managed) speed of appreciation of the Chinese currency, with the US urging faster appreciation in view of the apparent undervaluation of the Yuan. These consultations have been part of the “US-China Strategic Economic Dialogue,” recognized on both sides of the Pacific as a successful framework for US-China discussions.  We hope the Obama team will continue this dialogue. There is little evidence in history of belligerency and confrontation yielding positive results. Rather, in this case, they risk affecting the willingness of China to continue to accumulate US securities, essential for the financing of our huge and growing debt, while stoking dangerous protectionist sentiments in the US.  Following the example of the Smoot-Hawley Act of 1930 would be the surest way to turn the current serious recession into a depression.

Finally, we would note that a stronger Chinese currency would not necessarily mean a dramatic improvement in the US- China balance of trade.  Many Chinese firms are likely to have considerable scope to absorb the impact of a stronger currency. They weathered an overnight 30% revaluation during the Asian crisis and emerged in good shape.  Moreover, their costs of imported raw materials would be lowered by currency revaluation.  Industries where margins are tight in China are being phased out, in any event, and are moving to lower-cost countries such as Viet Nam. 

While the Obama team should continue the currency consultations and encourage the Chinese to move in a direction that would be in the long-term interests of China as well as the global economy, the Strategic Economic Dialogue should give at least equal emphasis to encouraging efforts to promote domestic consumption and to pressing for further opening of Chinese markets.  These efforts should be backed up by effective use of the World Trade Organization to hold the Chinese to their WTO commitments..