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Busch: The Krugman and I

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On Sunday, Paul Krugman wrote an op-ed for the NYTon his China fears. One of the major themes that Krugman (and I) are concerned about is the imbalanced adjustment process for the US weak economy via currencies. In a free floating regime, the country that is experiencing weak or negative growth sees its currency weaken against others to help stabilize the economy via increased exports. However, this is not the case when China pegs its currency to the US dollar. As Krugman explains succinctly, "At this exchange rate, Chinese manufacturing has a large cost advantage over its rivals, leading to huge trade surpluses."

He draws this conclusion: "The bottom line is that Chinese mercantilism is a growing problem, and the victims of that mercantilism have little to lose from a trade confrontation. So I’d urge China’s government to reconsider its stubbornness. Otherwise, the very mild protectionism it’s currently complaining about will be the start of something much bigger."

Writing in the FT today, the ECB's Bini Smaghialso echoes this theme and the concern over increased trade suit activity. His explanation of the perpetuation of this structure: "In China, the persistence of an undervalued currency has over the years effectively subsidized exports. As the export sector has grown over time, the “subsidy” has given it a disproportionate importance, not only in terms of output and employment but also with respect to its influence on political decisions....Overall, the global crisis seems to have strengthened the influence of those parts of society favoring a continuation of the current regime and weakened the voice of those asking for much-needed reform. As a result, short-term goals may once again be allowed to override balanced and sustainable economic policies."

Bini Smaghi draws the same conclusion that Krugman does: "A more balanced exchange rate regime would encourage higher savings in countries with current account deficits as well as reduce protectionist pressures, now on the rise in response to competitive distortions."

Today, Zhang Xiaoqiang, a vice-chairman of the National Development and Reform Commission, the country's powerful central planner, summed up the situation by saying that quantitative easing in rich countries, a weakening dollar and China's economic recovery were set to create additional pressure on the yuan.

While I rarely agree with the Nobel prize winning Dr. Krugman, I have to admit this is exactly the risk the Chinese face. The odd twist to this is that the United States will not be leading the way on bringing trade suits to the WTO. It will be our trade partners bringing the heat as they have felt the lopsided adjustment fall on their shoulders. While the Chinese are adamant about keeping the peg, the pressure will continue to build via WTO suits and tariffs especially if Chinese growth remains well above the G7.

The use of the massive Chinese US dollar reserves for either capital injections into their banks or for purchasing commoditieswill heighten global awareness of their trade policies.

With every quarterly release of a +8% GDP growth, China will feel the ire grow and trade sanctions multiply. Slower than expected 2010 growth in the G7 can make this situation explosive.

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Andrew B. Busch is Global Currency and Public Policy Strategist at BMO Capital Markets, a recognized expert on the world financial markets and how these markets are impacted by political events, and a frequent CNBC contributor. You can comment on his piece and reach him hereand you can follow him on Twitter at http://twitter.com/abusch.