Well it’s out the first step has been taken by US legislators in initiating what could be an all trade confrontation between the world’s largest and the world’s fastest growing economies. Released shortly after the US Treasuries exchange policy evaluation, US legislators made it clear that flexibility must be the number one priority of Chinese policy makers.

The new bill, should it become US law would enable the US Treasury to coordinate intervention in the currency markets if there is fixed proof that the country’s currency is “fundamentally undervalued”. Although targeting every global participant, the central theme is clearly China and its rather rigid currency regime. Including potential participation from the International Monetary Fund and World Trade Organization, does the bill really turn heads in Beijing?

Although the bill does reek of protectionism, the piece of legislation itself is visibly less harmful than the Graham-Schumer bill from last year. Dismissed on the advice of then newly initiated Treasury Secretary Paulson, the Graham Schumer initiative aimed at implementing tariffs of up to 27.5 percent of all Chinese imported goods. This time around, with the approval stamp of Democratic representatives Charles Schumer of New York and Max Baucus of Montana, as well as Republicans Lindsey Graham of South Carolina and Charles Grassley of Iowa, the bill looks to take the route of American currency intervention in the markets, something that hasn’t happened for approximately 7 years. However, the actual intervention, under the auspices of the legislation, would take a considerable amount of time from start to finish. In order for intervention to take place:

• The US Treasury Department’s twice a year report would identify "misaligned currencies" and not just currency manipulators. This is a shift from requiring that the Treasury find evidence that the country is deliberately trying to get a trade advantage.

• Should the valuation be “misaligned” the US Trade Representative would have one year to officials file complaint with WTO officials.

• Once filed, the complaint would then reach the US Treasury, which would consult with the Federal Reserve and other global central banks in considering the possibility of intervening in the foreign exchange markets. Thus punishing the guilty country.

The lag time in the actual order of events would take a minimum of a year to implement, a considerable amount of time for any economy to set wrongs right. As a result, similar to previous WTO sanctions by the US, the results would take far longer than desired by officials and affording the punishable party ample time to correct any iniquities.

China and the US Need Each Other
Markets are already seeing nascent animosity as China countered today’s legislative announcement. Although recognizing that the US has “legitimate” concerns with the enormity of China’s trade surplus, Chinese Ambassador Zhou Wenzhong stated that legislative action “will hurt opportunities for healthy business activity between China and the United States. The sentiment was backed by protests from China’s Ministry of Foreign Affairs. According to the ministry’s spokesman Qin Gang, “the US Congress believes it (yuan) is too low….but whose standard is this? Ultimately, China’s renminbi exchange rate must suit Chinese realities.” All bite, the comments leave one essential fact out, interdependence is a necessity. China’s reliance on the US, and vice versa, will continue to curb efforts of a blown out trade war. Although policy makers won’t admit it, China continues its attempts to tap the world’s richest economy in the US, it’s largest overseas market. The notion has sparked not only acquisitions of key manufacturing companies, like Lenovo for retail laptop creation, but also plans to expand domestic consumer automobile manufacturing. On the other hand, Chinese officials have just expanded the potential influence of American companies, allowing more access to financial services and expanded air travel ventures for US based firms. Should a trade war ensue, however, efforts will be lost by both parties as protectionism is sure to keep viable markets in both countries off limits.

On the investment front, China cannot stop buying US dollars. Their current bond market is one tenth the size of the US bond market. The average bond market valuation currently stands at approximately 95 percent of overall GDP while China ‘s market only represents 30 percent to GDP. With the US dollar likely to comprise a big portion of its managed float, as much as China tries to diversify, some of their money will still be used to buy US dollars and US treasuries. Comparatively, this also means that China’s bond market has plenty of growth potential. Expect US investors to aggressively try to get a piece of that pie.

Only When the US Slaps Big Sanctions on Steel, Should FX Traders Be Worried
Only if the US decides to impose clear cut tariffs on imported Chinese goods, should FX traders be worried because this will force Chinese officials to think up retaliatory sanctions on its own swath of US imports. Mainly in focus would be China’s steel exports. Now considered the world’s largest producer of the steel and coiled steel products, China would see its global market share decrease in the unlikely event. The situation would couple well with already considered sanctions by the EU as policy makers there look to protect their own industrial producers of the base metal. As mentioned before, China could counter by hastening the pace at which US dollar reallocation takes place. Already amassing an FX reserve of $1.2 trillion, standing as the world’s fourth largest, China could essentially begin unloading a good majority of its $400 billion dollar position in the market. The move would crimp dollar demand and ultimately add an unnecessary weight to the underlying currency. Although good for American exporters, as a depreciated dollar would add to the overall competitiveness of the sector, the massive depreciation would have longer term negative effects on China. Much of Chinese growth is dependent on US demand. If the US economy slows as China’s dumping of US treasuries drives up yield, demand for Chinese goods will falter as well.

Conclusion
Ultimately, today’s legislative creation looks to be another appeasement to American industry leaders. Although the bill does force Beijing to reconsider its current foreign exchange regime, the level of aggression is unlikely to spark any retaliatory measures by Chinese officials in the near term. As a result, unless hard fines and tariffs are placed on Chinese goods, continued talks will emerge in helping both parties work towards a more amiable currency valuation. The result will be a strained, but continuing two way trade relationship.

Richard Lee is a Currency Strategist at FXCM.