U.S. yuan raid idea is fascinating but flawed

A top think tank has advised Washington to declare a currency war on China. The proposal from the Peterson Institute to force up the value of the yuan sounds fascinating, but a direct attack may be hard to pull off in practice. Beijing is likely to respond better to multi-lateral persuasion.

Peterson has called for a U.S. raid on the forwards market for the yuan, which it believes has to rise at least 25 percent against the dollar. The timing is good. U.S. lawmakers are already threatening to slap tariffs on Chinese imports, and the 1.5 percent rise of the yuan in the past two weeks hardly looks enough.

Targeting China’s currency directly goes to the heart of the problem, whereas duties only address exports from China on a product by product basis. Foreign traders can’t buy yuan in large quantities because of China’s strict capital controls, so the next best thing is “non-deliverable” forwards.

These forwards, where no yuan actually change hands, don’t directly impact the exchange rate. But a big rise in their value could give China a headache. If forwards seemed to price in strong appreciation, it could attract speculative inflows and make China’s asset bubbles worse.

While this idea is fascinating, the execution would be tricky. The size of the forwards market is just $1 billion on a volatile day. The United States could not intervene in such a small market without being noticed. That would risk inviting counter-trades by arbitrageurs, who might sell forwards even as the United States buys.

Beijing might also inflict losses on would-be raiders. If it resolutely fixed the yuan below the forward price, the trader would make a loss. Washington may thus struggle to find investors willing to do its bidding. Unlike Beijing, it doesn’t control its financial institutions, so can’t tell them to carry out unrewarding trades.

The biggest problem with Peterson’s idea, though, is that Washington can’t really justify manipulating the yuan when it is blaming Beijing for the same thing. Two wrongs don’t make a right. Transparent, multi-lateral pressure looks a better way to call for change.