Paulson meets Hu in China -- Expect dollar decline

December 20, 2006

Treasury Secretary Henry Paulson led the highest-ranking delegation of U.S. government officials to meet with China's President Hu Jintao and his deputies to initiate a series of economic dialogues.

Paulson agreed to take steps to increase the U.S. savings rate, while Hu agreed to continue measures to increase China’s domestic consumption, exchange rate flexibility and intellectual property rights protection. China’s economic plan for 2007 called for reducing its record $168 billion trade surplus by encouraging domestic consumption and increase imports.

The two sides also agreed on the following:

• The New York Stock Exchange and the NASDAQ will open offices in China.
• Set up a working group to negotiate opening up China’s services sector to U.S. imports. The services sector represents 70% of the U.S. economy.
• Relaunch air service negotiations in January, including establishing a direct flight from Washington to Beijing.
• Cooperate in energy use issues, facilitate travel, and develop lending.
• Work together to further open China’s banking industry. This financial infrastructure needs to be in place for China to further loosen its exchange rate policies.
• Continue to work towards the successful completion of the Doha round of trade talks.

Also part of the trip, U.S. Commerce Secretary Carlos Gutierrez sponsored a series of trade agreements, including:

• Home Depot will purchase 12 Chinese home improvement stores, valued at $100 million.
• GE Aviation will sell and maintain 9 airline engines to Shanghai airlines, worth $550 million.
• Oshkosh Truck company and VeriSign also signed smaller deals.

In addition, U.S. Energy Secretary Samuel Bodman announced that China will purchase 4 nuclear reactors, worth up to $8 billion, from Westinghouse, now a subsidiary of Toshiba.

The next meeting is in Washington in May.

What Paulson's meeting with President Hu means:

Treasury Secretary Paulson is well positioned to effect a real alliance between the U.S. and China. The Chinese press bragged about how “half the Bush administration” attended the meeting, which means to the status-conscious Chinese that the U.S. is serious about improving its relationship with China. It also marks a turnaround from President Bush’s prior treatment of President Hu, which hurt the U.S. relations with this important country.

Good relations will be necessary for Paulson to be successful. He must convince the Chinese to lower the yuan while keeping isolationist Congressmen at bay.

Background on China's economy

China has been a little too successful in increasing growth, which is now at 10% a year. As a result, China exports $116 billion more to the U.S. than it imports. It has done this by keeping the yuan at artificially low rates, which makes its products cheaper than other countries. To keep the yuan low, it has had to buy dollars, which has kept long term interest rates low in the US. China’s foreign reserves is now at $1 trillion.

China’s leaders agree that reversing this imbalance would be good for its economy. It could spend its reserves on social programs, which would raise the living standard of its residents, which would increase confidence in the government, reduce the need to save, and spur domestic consumption. This would reduce reliance on exports, which makes China’s economy dependent on that of the US, which is declining.

By raising the value of the yuan, China could reduce exports and the trade surplus. In fact, it has raised the yuan by 4% since July 2005. However, many experts state it should let the yuan rise 20-30%. This would slow the economy and reduce local exporters’ drive to build capital equipment. Right now, China has over capacity in many industries, which could result in a recession if demand drops too quickly.

China must navigate very difficult economic waters. It must gradually shift from an export-led economy to a domestic-based one, while keeping economic growth fairly high but not over stimulating.

Action steps:
This trip was good for large cap multinationals, especially aerospace and tech, but bad for the dollar. However, many large cap funds hedge against for expected exchange rate changes.

Therefore, make sure you have a good allocation of large cap funds. Also, check out some things you can do to protect yourself from a dollar decline in the WorldMoneyWatch special report.

Source: U.S. Treasury Department, “Statement by Treasury Secretary Paulson”, December 15, 2006; English People’s Daily Online, “Strategic economic dialogue new opportunity for U.S. China relations, says Hu”, December 16, 2006; “First China strategic economic dialogue ends with a number of consensus”, December 16, 2006; “Major deals signed on eve of key talks”, December 13, 2006; “Dialogue eases tensions of surging foreign trade in 2006”, December 13, 2006.