"The Easy and Legal Way to Stop Currency Manipulation"

Daniel Gros:

A reciprocity requirement: The easy and legal way to stop currency manipulation, by Daniel Gros, Vox EU: The endless discussions about global imbalances, and China’s supposedly self-serving exchange-rate policy, have for a long time, resembled discussions about the weather; everybody talked about it, but nobody did anything. This is now changing. ...

The US political system has become so frustrated by this situation that Congress is now seriously considering whether to label the country a “currency manipulator” and impose trade sanctions which would be illegal under WTO rules and threaten to throw the global trading system into turmoil.

But there is another way. The US (and Japan) could easily prevent the Chinese Central Bank from continuing its intervention policy without breaking any international commitment. The US and Japan only need to invoke the principle of reciprocity and declare that they will limit sales of their public debt henceforth to only include official institutions from countries in which they themselves are allowed to buy and hold public debt. Instead of the “moral suasion”, tried in vain by the Japanese, the Chinese authorities would just be told that they can buy more US T-bills Japanese bonds only if they allow foreigners to buy domestic Chinese debt.

Imposing such a “reciprocity” requirement on capital flows would be perfectly legal..., there are no legal constraints on the impositions of capital controls.

This “reciprocity” measure would of course be equivalent to a very specific form of controls on capital inflows. Capital controls are always somewhat leaky, but not in this case because the Chinese Central Bank would find it difficult to hide its huge investments going through western financial institutions. No reputable financial institution would dare to become a hidden intermediary for the Chinese given that no institution bidding for hundreds of billions of T-Bills would take the risk of secretly fronting the Chinese government...

As a practical matter the introduction of the reciprocity requirement should provide a grand fathering of the existing stocks of Chinese official assets abroad (already above $2,500 billion). However, the Central Bank of China would not be able to continue its interventionist policy – and that is what counts for foreign exchange markets.

The immediate objection is, “What if the Chinese react emotionally and dump their holdings of T-Bills and US agency debt on the market? Would that not disrupt the US government debt market?” This “dumping” is not as simple as it sounds. What assets would the Chinese Central Bank buy when it sells T-Bills? There are not many choices if the Chinese Central Bank wants to dispose of thousands of billions of dollars. Either it holds cash in the form of bank deposits (this would mean a massive refinancing of the US banking system) or it buys other US assets (which would mean a refinancing of the US private sector). Moreover, the reciprocity requirement could be extended to private debt instruments as well. But this is probably not necessary as the Chinese Central Bank is unlikely to invest hundreds of billions of dollars (or euro) in private assets. Buying euro assets would of course constitute an alternative, but this does not appear too attractive at present, and would be prevented by the Europeans adopting the same reciprocity requirement.

The US might hesitate to impose a reciprocity requirement for sales of its public debt because (in contrast to Japan) it needs foreign financing for its public sector deficit. But this also constitutes the litmus test for the sincerity of the US position which cannot have it both ways, i.e. Chinese financing of its external deficit and an end to currency intervention. The choice is now up to the US, it can easily stop Chinese interventions without violating any international commitment if it is willing to rely on domestic savings to finance its own fiscal deficits.

I don't think most members of Congress would be willing to take the large risk they would attach to imposing reciprocity. But how large are the risks? Paul Krugman:

given the fact that we’re in a liquidity trap, a decision by China to buy fewer of our bonds would actually be doing us a favor — it would weaken the dollar, and help our exports.

Here's the latest: 

House Is Likely to Pressure China to Raise Renminbi: The House is expected to give the Obama administration another tool in its diplomatic pouch to pressure China to let its currency rise in value, reflecting growing concern around the country over the loss of manufacturing jobs, persistently high unemployment and a rising trade deficit.

In what is likely to be one of Congress’s last significant measures before the election, the House will vote Wednesday on a symbolic but not insignificant measure threatening China with punitive tariffs on its imports to the United States. ...

But it is unclear whether the legislation, which faces cloudy prospects in the Senate, will succeed this time in prodding a China that has become more self-confident on the world stage. ...

 

“The legislation will strengthen the administration’s hand in its negotiations with China, but also risks provoking a strong backlash,” said Eswar S. Prasad ... of ... Cornell and a former head of the International Monetary Fund’s China division. “Ultimately its short-term effect is likely to be more symbolic than substantive.” ...

Professor Prasad ... warned that if the Congressional proposal went forward, China could retaliate by limiting American imports or denying American manufacturers and financial institutions “the coveted prize of access to rapidly growing Chinese markets.”

A policy that is "more symbolic than substantive" is my expectation as well.