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Monday May 8, 2006 - 18:38:27 GMT
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Forex: US Treasury, To Name Or Not To Name...China

I am not sure whether the US Treasury Report on Foreign Exchange is setting up to be a Shakespearean tragedy or comedy. But the drama is filling dealing rooms and hedge funds with more speculation this side of G7 accord. And we have not had one of those since 1988 at Louvre. Only thing missing is a betting line at UK odds making shop. For all I know there may already be one.

First of all the US Treasury, like Bartleby the Scribner, would prefer not to. No to name China a manipulator. While the US Treasury feels it has been sufficiently patient for a faster pace to flexibility than what China has offered up to date, it does not particularly want a dog in this fight. China is as Treasury Spokesman Fratto reiterated today, committed to a flexible exchange rate and some progress has been made...just not enough.

To name or not to name has always been about Congress, not China and not free trade, for this administration (China was named twice under the Clinton administration). Congress faces a major election in November and being tough on China for cheap exports and sub-US wages (hence a prime destination for manufacturing outsourcing) will undoubtedly play well with the US public, already ahead of Congress on the drift toward protectionism (as seen over World Dubai Ports deal for US port management contracts and the backlash to illegal immigration). The equation here was the more incensed Congress (mostly the Senate) became over China's currency policy, the greater the risk China would be named by US Treasury for the simple reason it needed to placate Congress and keep the Senate from passing protectionist legislation.

But this dynamic changed after the Senate's two leading protectionists, Senators Schumer and Graham, traveled to China in late March to meet with officials and discuss currency policy. Schumer's about face was almost as fast as his usual dash to a television crew with a microphone. He came back a changed man. Graham was a little more suspicious but also seemed to have a reduced degree of urgency in pushing the Senate to vote on the Schumer-Graham China sanctions bill...reval or pay large duties (in time).

It seemed like the Senate had lost its appetite for a confrontation with China. Cooler heads seemed to be prevailing reducing the risk of naming China. And G& and the IMF took up the call at the April 21 G7, IMF meetings, making the yuan a multilateral not just a bilateral issue. So more offset to the paranoid Senate.

But then the moderate Senate Finance Committee Chairman Grassley, who had been earmarked by the White House and Treasury for sponsoring a competing bill to Schumer-Graham without the nuclear option, turned on Treasury and China. In late April Grassley went to the right of Schumer on the protectionist spectrum regarding China. he said the Treasury and White House were pussy footing with China and China was given an inch but taking a mile. He demanded that treasury name China a manipulator.

Naturally I though this could tip the scales back in favor of naming China. Again the entire notion was to placate Congress and not ignite a drive toward a trade war. Surely China understands the legislative dynamic the Bush administration is facing, even if it felt the reception for President Hu was less than gracious. China's political leadership would rather deal with the devil it knows in the executive branch than the devil it does not know in the legislative branch. It seemed to me that naming China would not be unprecedented, does not come with automatic sanctions, just hearings and state-to-state negotiations.

Get my drift? Naming is a less threatening outcome than not naming.

Then another path has bubbled to the surface. Under Secretary Adams back in January said the current trade law requiring the report to Congress is arcane and not very meaningful. He suggested a number of new designations and a more regular review process...presumably more currencies could be discussed and Treasury and Congress would not have to cut the currency management foot to fit the manipulator shoe. This line of thinking suggest the Treasury will not name China a manipulator but introduce new designation (not legally binding like manipulator) that would determine that the yuan is fundamentally misaligned. The idea here is it is enough for the hardliners in Congress (this I doubt) and does not risk declaring a trade war with China by naming it a manipulator (really not what the designation means).

Then Treasury's Fratto announced the release of the report for Wednesday at 4PM EDT but seemed to hint that China was doing enough not to be named a manipulator (I doubt this was his intention...he is careful not to tip off markets one way or the other). Indeed in the last report, released in November, Treasury said it would name China a manipulator unless it did more to allow flexibility into its exchange rate regime. Well the regime has been little changed since November apart from a few weeks were the Chinese authorities appeared to be accepting of a faster pace, within the confines of the July 2005 regime parameters, of appreciation. But Treasury officials have been very clear, as was Fratto today, that China has not moved fast enough.

My own feelings are name China and markets and China it is not an end to trade relations. Congress gets taken out of the trade relations equation at least for a while. After all protectionist legislation is the nemesis of the global expansion.

But feelings aside, the Treasury may well gamble that Congress will be sated by calling the yuan a misaligned currency if not naming China a manipulator. This seems to be the outcome a majority (albeit slim one) is expecting. If so then we may see dlr/yen bounce some. But I would sell any rally on Wednesday PM because I fully expect Congress to go ballistic unless China is named. That bandwagon will be much harder to control than naming China and at the end of the day a far worse outcome for the dollar generally, though especially versus the Asian currencies. In a world of trade skirmishes and war, beggar thy neighbor currency strategies are the rule not the exception.

I hope Treasury gets this right and names China a manipulator, with explanation, rather than not name it with new classification not legally sanctioned. Anything short of naming China would meet Grassley's definition of puss footing for sure.

David Gilmore


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