The “Undervalued” Yuan Saga Continues

The People’s Bank of China may be in a position to use its $1.33 trillion currency reserves as a bargaining tool against U.S. lawmaker demands. Xia Bin, director of financial research at the State Council Development Center, believes China can use its holdings of U.S. government debt to its advantage. As the world’s second-largest holder of U.S. Treasuries of $407 billion, the selling of U.S. asset holdings would significantly lower their value. U.S. Treasuries fell yesterday after traders cited in a U.K. Daily Telegraph report that China may threaten to sell its holdings in U.S government debt if the U.S. imposed trade sanctions (see more in an article by Kathy Lien).

On July 26^th, the U.S. Senate Finance Committee approved legislation that would place higher duties on Chinese imports. These higher duties should compensate for the undervalued yuan. U.S. lawmakers since the beginning of the year have expressed concerns that an undervalued yuan is hurting U.S. companies. The People’s Bank of China has bought huge sums of U.S. government debt in order to keep its yuan artificially low.

With a high foreign currency reserve, a central bank is able to issue more than sufficient amounts of its domestic currency to stifle demand. If demand decreases when the economy bottoms out, the central bank would have plenty of foreign reserves to buy back the domestic currency. The enormous influx of capital from its incredible trade surplus is what has allowed China to maintain the world’s largest foreign currency reserve.

Despite numbers for April and May this year showing cuts in PCB U.S. Treasury holdings after 17-months of purchases, the central bank has indicated it would cut holdings anytime soon. President Bush and Henry Paulson agree it would be “foolhardy” for China to cut holdings in U.S. debt. Selling off these assets would strengthen the yuan significantly and thereby lower export value. Both have indicated that a mutual trade flow without penalties on imports should persist. Yet, with its true actions always a secret to the public, it remains to be seen what the PCB will decide if U.S. import duties do come into play. The PCB could use its huge foreign reserves to put a dent into the U.S. economy. The situation has turned from a question of economic policy into a potential political showdown.