This analysis is from Sheena Martin, Contributing Editor, Investment U
Tuesday, November 17, 2009

The continually weak U.S. dollar is a constant source of debate among economists and the media.

And most of the chatter is decidedly negative. But there are a few benefits, including the effect it has on the bloated U.S. trade deficit. Both economists and the U.S. government are hoping that such dollar weakness will help reduce the nation’s trade deficit, one of the most criticized aspects of the U.S. economy.

Sure enough, during the recession, America’s trade deficit with many other countries has shrunk. It’s already seeing increased exports of locally produced goods with falling demand for imports of highly priced foreign goods.

But then there’s China – one of the largest exporters to the United States…

By pegging the yuan to the U.S. dollar, American imports of Chinese goods are artificially cheaper and give American companies opening factories in China a contrived subsidy. This explains the soaring trade imbalance with China, which holds 83% of American’s non-oil trade deficit.

Consequently, the Obama administration has implemented additional tariffs on imports of both steel and tires from China. And unsurprisingly, China has criticized these actions as “trade protectionism,” expressing fear that the United States is more concerned with propelling itself out of recession, rather than aiding China’s economic interests.

No surprise there either!

China Faces Obstacles With Ties to the Weak U.S. Dollar

That said, China also faces obstacles, due to its close ties with the weak U.S dollar.

Liu Mingkang, Chairman of the China Banking Regulatory Commission, says the weak dollar and low interest rates have created “unavoidable risks for the recovery of the global economy, especially emerging economies.”

Without a doubt, this has forced China to pay close attention.

In its third-quarter monetary policy report, the People’s Bank of China suggested that it might consider using a basket of other major currencies – not just the dollar – to guide the exchange rate.

In light of this, China has been diversifying its foreign exchange reserves (which top $2 trillion) in order to move away from the dollar into other major currencies and to hedge against the U.S. dollar’s fall. This gradual diversification will help avoid bid market fluctuations, while allowing the yuan to appreciate for the first time in 18 months.

Moreover, choosing to strengthen the yuan would represent a major policy shift and could alleviate problems between the weak U.S. dollar and the yuan. That’s because U.S. and European manufacturers would benefit from cheaper exports in China, in addition to decreasing America’s trade deficit with China.

On the other hand, costlier Chinese goods could create other problems, such as pushing up U.S. inflation and potentially causing the Fed to hike interest rates.

The easiest way to play this situation without having to directly dive headlong into the world of currencies is to consider an ETF like the WisdomTree Dreyfus Chinese Yuan Fund (NYSE: CYB). The fund’s goal is to reflect money market moves in China and changes in the yuan against the dollar. This could be a wise move for investors as China looks at strengthening its domestic currency.

Good investing,

Sheena Martin

View original at: Investment U

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