A wonderful chart courtesy of the Council on Foreign Relations depicting what I described several weeks ago: Since announcing its renewed commitment to currency flexibility in the days leading up to the G20 summit, the appreciation of the yuan has been more symbolic than substantive…

click on the chart for a crisper image, or visit China’s Head Fake

As I wrote several weeks ago (see Currency Manipulator):

China’s strategy of publicly announcing a more flexible yuan policy in the days leading up to the G20 summit effectively deflected the debate away from the yuan. What’s more, China’s announcement was seemingly rewarded by a Treasury now more reticent to label it a currency manipulator.

The interesting thing to me about the whole thing is that the yuan has barely budged since the announcement, rising less than 1% since late June. For a currency that some claim is undervalued by as much as 40%, that’s not likely to make much of a dent in persistent trade imbalances.

According to the CFR

In the run-up to the June G20 summit in Toronto, China came under significant U.S. pressure to loosen its currency peg to the dollar…Then one week before the summit, China announced that it would relax the peg, and indeed the renminbi (RMB) began to rise. The political tension dissipated. Yet since July 2^nd, five days after the summit, the RMB has ceased rising.

Taking stock then, China’s most recent flexible yuan policy announcement seems to have been wildly successful. It quelled political criticism. It effectively avoided having the yuan become a topic of discussion at the G20 meetings. And it was rewarded by both the Treasury and the IMF, neither of which labeled it a currency manipulator in post-G20 currency assessments – opting instead for the much more benign label “undervalued” (see the Treasury’s Interim Report on Exchange Rate Policy and IMF Yuan Debate).

So in effect, China’s cheap talk has worked, …so far. The nagging question for US policymakers: Now what??

…at least not according to the US Treasury (see the Treasury’s Interim Report on Exchange Rate Policy).

According to the Treasury’s report:

China’s continued foreign reserve accumulation, the limited appreciation of China’s real effective exchange rate relative to rapid productivity growth in the traded goods sector, and the persistence of current account surpluses even during a period when China’s trading partners were in deep recession together suggest that the renminbi remains undervalued.

It was easy to overlook the recently released Treasury report in the wake of the G20 summit, where much of the debate centered on austerity versus stimulus rather than China’s mercantilist policies (see Agreeing to Disagree).

In this sense then, China’s strategy of publicly announcing a more flexible yuan policy in the days leading up to the G20 summit effectively deflected the debate away from the yuan. What’s more, China’s announcement was seemingly rewarded by a Treasury now more reticent to label it a currency manipulator. And the timing of the report’s release (after months of delay) seemed rather coincidental: It was released after the conclusion of the G20 meetings, and only after China seemed to mollify critics with its announced policy shift.

The interesting thing to me about the whole thing is that the yuan has barely budged since the announcement, rising less than 1% since late June. For a currency that some claim is undervalued by as much as 40%, that’s not likely to make much of a dent in persistent trade imbalances.

Now I’m as much a proponent of free trade as anyone (see Globalization Revisited and Globalization Discontents), but my view is that trade should be allowed to take place in an environment in which economies adjust as a consequence. Explicit policies that prevent such adjustment can be damaging to all parties.

With my bias now laid bare, it seems to me that China is simply paying lip service. It wants to appear accommodating, publicly declaring its intention to allow the yuan to strengthen against the dollar, while continuing to rely on exports to the US as its main growth engine.

Given the recent turmoil in Europe (China’s second largest trading partner), maintaining its exports to the US has taken an even heightened importance (see Revaluation Postponed and Revaluation and Euro Weakness). And in a world where everyone suddenly wants to play beggar-thy-neighbor (China, Japan, and now even Europe), the US is now everyone’s neighbor (for a brilliant treatment of the issues see Capital Tsunami).

This cannot continue indefinitely.

Against that backdrop, don’t be surprised if the trade deficit and cries of unfair trade practices begin to occupy a more prominent place in political discourse.

It’s been a long time since I’ve thought about the JP Morgan/Bear Stearns shotgun wedding (see Rescue for Bear? and Rescue Update for background). Back when I wrote those blog entries, I wondered aloud whether, in addition to preventing Bear’s collapse, the Fed also orchestrated a backdoor bailout of JP Morgan in the process.

Anyhow, as part and parcel of the JP Morgan/Bear Stearns deal, the Fed acquired a host of assets that were packaged into what would become known as the Maiden Lane portfolio. The Maiden Lane portfolio housed approximately $30B “worth” of assets, with JP Morgan agreeing to assume the first $1B in losses associated with the portfolio, and the Fed assuming any losses thereafter.

Last week an interesting article in Bloomberg questioned when the Fed knew about the poor quality of the assets it acquired in the Maiden Lane deal, and how it communicated what it knew about those assets (see Fed Made Taxpayers Unwitting Junk-Bond Buyers).

According to Bloomberg:

Federal Reserve Chairman Ben S. Bernanke and then-New York Fed President Timothy Geithner told senators on April 3, 2008, that the tens of billions of dollars in “assets” the government agreed to purchase in the rescue of Bear Stearns Cos. were “investment-grade.” They didn’t share everything the Fed knew about the money.

The so-called assets included collateralized debt obligations and mortgage-backed bonds…that were so distressed, more than $40 million already had been reduced to less than investment-grade by the time the central bankers testified.

At the time Maiden Lane was created, the Fed claims that the assets were solid, credit-worthy, and investment grade.

“As was noted in testimony, all of the cash securities in the Maiden Lane portfolio were investment grade on March 14, 2008, when the deal was agreed to in order to facilitate the acquisition of Bear Stearns and to prevent the systemic consequences of its sudden and disorderly failure,” Michelle Smith, a spokeswoman for the Fed’s Board of Governors, said in an e-mail.

“The Federal Reserve considered not just credit-rating valuations, which have varied some over time based on economic conditions, but also relied on a separate assessment from an independent investment firm, which advised us that over time, we would likely fully recover our principal and interest,” Smith said. “We continue to expect the loan to Maiden Lane to be fully repaid.”

“You’ve got about $30 billion of collateral. And some comments have been made that you feel comfortable because it’s highly rated,” Senator Jack Reed, a Rhode Island Democrat, told Bernanke, according to a transcript. “But a lot of highly rated collateral these days is being subject to questions.”

“Senator, as was mentioned, it is all investment-grade or current performing assets,” Bernanke responded. “We do not know for sure what will transpire,” he said. “But we have engaged an independent investment-advisory firm who gives us reasonable comfort that if we can sell these assets over a period of time that we will recover principal and interest for the American taxpayer.”

That was then. This is now:

More than 88 percent of Maiden Lane’s CDO bonds and 78 percent of its non-agency residential mortgage-backed debt are now speculative grade, according to data compiled by Bloomberg based on holdings as of Jan. 29.

Casablanca moment: I’m shocked, shocked…

Needless to say, I’ve been stewing over that article for the better part of a week now, and several thoughts came to mind:

1. The Fed was fleeced. It was in over its head – unable, and unequipped, to properly value extremely complex derivatives – and as a result, was on the wrong side of the Maiden Lane trade.
2. The Fed knew best. It was a liquidity problem and not a solvency problem. The Fed bought assets that no other party was willing to buy because potentially interested parties were scared (wrongly pricing Armageddon). The assets still had value and the Fed paid a fair price. To its credit, even the CBO estimates that the Fed will end up realizing a $200 million return on its Maiden Lane investment. So the Fed was on the right side of the trade.
3. It doesn’t matter whether the Fed made a good or bad trade. It failed to properly disclose information about the true state of the Maiden Lane assets. That is, the Fed knew that the assets were largely junk but bought the assets anyway in an effort to wind Bear down in an orderly manner and stave off the risk of a systemic collapse.

I hope the answer doesn’t lie behind Door #1. It oughtn’t. There are some pretty sharp minds at the Fed, so I highly doubt they got taken. If the Fed executed a horrible trade, then how could it possibly be seen as a credible central bank, especially in light of the increased regulatory powers that the financial reform bill looks set to grant it? And as Kevin Warsh stressed in a recent speech: “The Fed’s institutional credibility is its most valuable asset…”

I am also skeptical that the answer lies behind Door #2. I keep coming back to the absence of suitors for Bear (and/or those assets). Why was there no market for Bear? Why was nobody interested in what were then largely “investment grade” assets? Did the market really have it that wrong?? As the Bloomberg article notes:

“Why wouldn’t JP Morgan want a bunch of AAA assets?” said Mark Calabria, a former Senate Banking Committee staff member…“The answer is it was all borderline junk.”

The CBO even leaves a wide range for expected returns on Maiden Lane’s assets recognizing in its report that, “the returns realized on asset-backed securities such as those in the Maiden Lane portfolios could deviate significantly from what is expected…”

And so we come to Door #3. Whether the Fed executed a good or bad trade is, in some ways, immaterial. It’s about the way it was handled.

I understand the desire, and the urgency, on the part of the Fed to step in and wind down Bear, much as the FDIC acts as a receiver to failed banks. I am one of those who believes that the alternative (letting Bear fail in a disorderly manner) might have had catastrophic consequences for the global financial system. Of course, we will never know, not having the opportunity to observe the counter factual.

But to me, this is starting to look like a case in which it’s debatable whether the ends justify the means.

As I understand it, the issue is that the Fed did not (at the time) have resolution authority over non-bank financial institutions such as Bear. Therefore, it invoked Section 13(3) of the Federal Reserve Act, which enables it to provide credit to corporations like Bear in extraordinary circumstances, but only in exchange for high quality collateral. Moreover, whereas the FDIC is funded by the premiums collected from member banks and draws upon the Deposit Insurance Fund when winding down a bank, in this case the Fed put taxpayer money directly at risk.

And therein lies what bums me out so. It’s not the kind of assets acquired by the Fed. It’s not the price at which the Fed acquired the assets. It’s not whether the assets will ultimately get paid back, though that’s important (and debatable). It’s not even whether the Fed, through its actions, effectively rescued the financial system from the brink.

In the end, it’s about what the Fed knew about the quality of the assets when it structured the rescue, and the possibility that the Fed put taxpayer money at risk in violation of Section 13(3) of the Federal Reserve Act, perhaps knowing ex ante that it was acquiring collateral of dubious quality.

This is why, in my opinion, Bernanke was so careful with his language in his April testimony. Yes, technically, the assets were investment-grade rated and/or performing assets when Maiden Lane was created. Therefore, at the time, the assets were likely meet the “indorsed or otherwise secured” criteria. Brilliant really, if you think about it.

But did the Fed anticipate that the assets would remain high quality? That’s another story.

If the Fed knew that the Maiden Lane assets were likely to become junk assets irrespective of how they were rated at the time (and we might never find out), it would be eerily reminiscent of a “You can’t handle the truth” kind of moment, …which speaks to a whole different kind of credibility.

In January I predicted that “major” bankruptcies in 2010 would number around 300 (see Notable Bankruptcies of 2010: Q1). According to Bankruptcydata.com, there were 59 “major” filings in the first half of 2010. Assuming that bankruptcies are equally distributed throughout the year, this puts us on pace for around 120 bankruptcies. Again, this would be well shy of my prediction.

In previous posts I discussed why I believed “major” business bankruptcies were tracking below expectations (see Notable Bankruptcies of 2010: Q1 and Notable Bankruptcies of 2009). The candidate explanations include: an improving economy; massive government stimulus/liquidity programs keeping structurally weaker firms on artificial life support; and the recovery disconnect between Main St. and Wall St. (i.e., small-firm bankruptcies are on the rise even while major bankruptcies have declined).

Personally, I continue to believe that the significant dip in “major” business bankruptcies that we have witnessed over the past year has a lot to do with the extraordinary government stimulus and liquidity programs. Nowhere has this been more evident than in the disconnect between the bankruptcy patterns across small and large corporations (see Notable Bankruptcies of 2010: Q1 for details). And as I’ve maintained all along, absent a second round of stimulus, we will find out if my hypothesis is correct as the stimulus and liquidity programs begin to wind down. In this sense then, the true test for corporate balance sheets (and by extension, the economy) will come in the second half of the year.

Given the recent troubles in Europe and the softer economic employment and growth numbers at home, it continues to be my expectation that the pace of corporate bankruptcy filings will increase in the second half of 2010. Will we ultimately reach 300 “major” business bankruptcies? At this point, likely not. But I do not think 200 is out of the question.

If fundamentally weak companies are being propped up by an artificially-stimulated economy that cannot structurally support them, it is only a matter of time before bankruptcies begin to reflect true underlying economic fundamentals.

Anyhow, below you can find an updated list of what I see as the “noteworthy” bankruptcies of 2010, as reported by Bankrupctydata.com. New additions since March appear in RED (please note that this is not an exhaustive list):

• Affiliated Media, Inc. (Newspapers)
• American Mortgage Acceptance Company (Real Estate)
• Anthracite Capital, Inc. (Real Estate)
• Atrium Companies, Inc. (Windows and Doors)
• Beach First National Bancshares, Inc. (Banking)
• Black Gaming, LLC (Gambling)
• Chem Rx Corporation (Pharma Services)
• Community Bancorp (Banking)
• Corus Bankshares, Inc. (Banking)
  
• Electrical Components International, Inc. (Manufacturing)
• EnviroSolutions Holdings, Inc. (Waste Disposal)
• Evergreen Bancorp, Inc. (Banking)
• FirstFed Financial Corp. (Banking)
• Haights Cross Communications, Inc. (Publishing)
• International Aluminum Corporation (Real Estate)
• Mesa Air Group, Inc. (Airlines)
• Morris Publishing Group, LLC (Media)
• Movie Gallery, Inc. (Retail)
• Neenah Enterprises, Inc. (Manufacturing)
• Neff Corp. (Construction)
• Orleans Homebuilders, Inc. (Real Estate)
• Penton Business Media Holdings, Inc. (Media)
• Point Blank Solutions, Inc. (Security)
• Regent Communications, Inc. (Media)
• R&G Financial Corp. (Banking)
• Saint Vincent’s Catholic Medical Centers (Healthcare)
• Spheris Inc. (IT Services)
• TierOne Corporation (Banking)
• The Newark Group, Inc. (Paper)
  
• Uno Restaurant Holdings Corporation (Restaurants)
• US Concrete, Inc. (Construction/Basic Materials)
• Xerium Technologies, Inc. (Paper)

Another G20 summit meeting has come and gone. The heads of the eight leading industrialized nations, the G8, met first on Friday and Saturday, followed by the full G20 complement, representing the twenty most important global economies.

The primary agenda for this summit was the global financial system and the world economy. Throughout the meetings, pronouncements of shared financial goals and economic cooperation were so frequently and publicly communicated as to become cliche, …not entirely unexpected for these kinds of events.

Was meaningful progress made and consensus achieved? It’s too early to tell (see a brilliant version of the communique in the Wall Street Journal, annotated by Marc Chandler, Simon Johnson, and Arvind Subramanian).

The desire for coordinated action on the global financial system and agreement on fiscal policy is certainly admirable, but the fact remains that each nation faces a differing domestic situation, and uneven economic and political pressures at home. Considering their differences, the fact that any consensus could be reached, let alone communicated, must be considered an accomplishment.

However, the most interesting storyline of the meetings was the tension between U.S. and European approaches to fiscal policy: spending versus austerity.

The U.S. position has always been that “pulling back spending too quickly could choke off the economic recovery.” On this count, Obama’s entreaties were acknowledged, “We must recognize that our fiscal health tomorrow will rest in no small measure on our ability to create jobs and growth today. In short, we have to do everything in our power to avoid a repeat of the recent financial crisis.” Meanwhile, agreements on targets for getting economic deficits under control, credibly committing to reducing deficits in the medium-term, and pledging to cut them in half by 2013, appeased European austerity proponents.

Although the gathering did not produce a uniformly agreed-upon fiscal solution, the consensus achieved could be described as one of “broad commitment to sensible long-term austerity.” Basically, participants agreed to ease into austerity – with some advocating for a quicker pace than others, …and plenty of room for individual interpretation.

At the end of the day, growth is the primary challenge for struggling economies around the world. Renewed growth will lead to increased tax revenues and the cash flow necessary to curb deficits, and ultimately, pay down debt. Although aggressively reducing government spending and increasing taxes seem intellectually appealing as solutions to deficit problems, reducing unemployment will be a real challenge for those countries that adopt austerity measures too soon. At the end of the day, the mechanism through which painful near-term austerity measures will increase employment and foster growth remains unclear, and threatens to derail whatever fragile economic recovery is currently underway. So countries with no immediate market-mandated need to impose austerity ought tread carefully.

Regardless, the paths to which the U.S. and its European counterparts have committed will, in the end, provide ample opportunity to observe, and debate, the long term economic consequences of their divergent fiscal approaches.

———————————————————————————————————

Parts of this opinion piece were co-written with Tom Cleveland, market analyst at Forex Traders, and I thank Tom for his contributions.

Just returned from a visit to Iceland, …hence the radio silence. Was there for a few days of work, followed by a few days of pleasure.

What an amazing place. The country is absolutely stunning in its beauty. And the people are absolutely wonderful. I can’t wait to go back.

That said, it’s sad, really, that the majority of Icelanders don’t seem to understand the full gravity of the debt problems that they currently face (for background see here). If they decide to go along with the current debt repayment plan they will have to accept years of sub-par growth at a minimum, and potentially, live through a few years in which they teeter on the verge of default. Refusal to pay now, however, could quickly propel Iceland into economic crisis as foreign credit dries up and hard currency becomes scarce.

What a mess!

Personally, I think that in voting down the most recent Icesave Referendum, Iceland is trying to play hardball with the UK and the Netherlands, hoping it will lead to a more favorable negotiated settlement while convincing them to shoulder some of the burden for the outstanding debt.

I hope they (the Icelanders, Brits, and Dutch) can work it out.

If not, that would make my movie choice on the flight over somewhat ironic. I found it interesting that Iceland Air would even offer “Wall Street” for its passengers as an in-flight option; but ironic how, for Iceland, Bud Fox’s sales pitch touting “extraordinary opportunities emerging in the international debt markets” might desperately be put to use.

So after Fox 5 shifted the originally planned segment from Monday to Tuesday and changed the time from 7:15am to 8:15am, they finally ran their story on the New York MTA. See the embedded video below.

If the video doesn’t work for you, feel free to visit Fox’s website (see Where the MTA Spends Money). In a story accompanying the video, Fox writes:

With an $800 million budget shortfall that has resulted in service cuts and the looming possibility of fare hikes, the MTA should look to cutting employee costs, Robert Salomon, a professor at the NYU Stern School of Business told Good Day NY on Tuesday.

“I think that’s the elephant in the room,” said Salomon.  “A full sixty cents on every dollar goes to employee costs”

From salaries, to health benefits and pensions, a significant amount of money is spent on employees.

MTA officials have said there are consolidating functions to reduce unnecessary spending, but at the end of the day, Salomon says it’s up to elected officials to force changes on the agency.

“It’s up to legislators to say enough is enough,” added Salomon.

Unfortunately I didn’t get to touch upon all the points that I came prepared to discuss, but I guess that’s what happens in a short segment.

I came armed with data. For example, not only do employee costs account for some 60% of the overall MTA budget, but its employment cost structure compares unfavorably with other large municipal transportation authorities (e.g., Boston, DC, and Chicago) and even a privately-operated transit company (e.g., Keolis). Believe it or not, the MTA spends in excess of $100,000 per employee in pay, benefits, and pensions ($7.2 Billion annually). It doesn’t even collect enough in revenue ($6 Billion in fares, tolls, etc.) to cover its employee costs.

That said, it was not my intent to bash unions on the show. I certainly hope it did not come across that way.

I am not anti-union by policy; however, the fact is that in the midst of the worst recession since the Great Depression, MTA employees are not sharing in the pain. In fact, in December 2009 the MTA was forced to grant a three year pay increase of 11% to the employees represented by the Transit Workers Union (TWU). This leaves commuters and taxpayers to shoulder the burden not only for the previously anticipated MTA budget shortfall caused by the financial crisis, but also the added shortfall caused by the mandated TWU pay increase.

This begs the question: How much more in taxes, service cuts, and fare hikes (which have significantly outstripped inflation over the years) can the commuter/taxpayer absorb???

And the worst of it is that absent the involvement of legislators, nothing can be done about the contracts that bind the MTA to overly-generous pay packages. This is why I said that simply streamlining existing operations and shedding administrative employees is not enough. It’s up to our elected officials to intervene, more equitably divide the pain among the parties involved, and say “Enough is enough!”

Given that the unions hold incredible sway with our public representatives, I am not holding my breath…

I will be appearing on Fox 5′s Good Day New York tomorrow morning (Tuesday) for a segment on the (mis)management of the New York MTA at 7:15am (changed to 8:15am). They want to discuss not just the financial trouble the MTA currently finds itself in, but also the organizational constraints that the MTA faces in trying to run as a leaner, more efficient organization.

The thing that strikes me about the MTA is how much of the organizational budget is dedicated – in some way, shape, or form – to employee costs. Nearly 60% of the total budget is comprised of payroll, overtime, benefits, and pensions. Wow!

The MTA does not compare favorably with its peers in this respect. And given the current structure of its contracts, I’m not sure there’s much the MTA can actually do about it in the near term.

Feel free to tune in if you’re interested in this topic, …and I’ll post a clip after the segment airs.

In a post several days ago (see Yuan Revaluation, Euro Weakness, and the US Recovery), I suggested that while I believe that the yuan ought to be revalued vis-a-vis the dollar, the crisis in Europe would likely put any such plans on hold. I wrote,

…although I agree that China needs to address the yuan-dollar peg, a gradual revaluation to competitive levels is probably the best outcome for the global economy. A sudden rise in the value of the yuan could come with painful near-term adjustments that derail the currently fragile global recovery.

But that said, there’s now an additional complicating factor: With the euro depreciating against both the dollar and the yuan, any plans that Chinese policymakers may have had to revalue the yuan against the dollar are likely to be put on hold…

Sure enough, there seems to be some chatter emanating from China that its policymakers are considering delaying a revaluation (see Yuan Revaluation Could Be Postponed, ht BA). According to the People’s Daily:

Worried about a depleting trade surplus and a possible slowdown of its economy later this year, China is not likely to accelerate pace to revalue its currency, the yuan, experts revealed.

The Beijing-based China Daily reported Wednesday that the chances of an early revaluation of the renminbi look unlikely and could happen much later than expected, considering that the nation’s trade surplus may see steep erosions due to the European debt crisis and the growing trade protectionist measures against China.

Interestingly, and quite compellingly, Michael Pettis argues that this is exactly the wrong response (see Don’t Misread the Euro Crisis). Instead, he argues that now is precisely the time for China to change its trade policy.

The Greek crisis, rather than reduce the urgency for China to revalue its currency and adjust its trade policy, may on the contrary require that China react much more aggressively than originally planned. Why? Because any sharp adjustment in trade or capital flows in one part of the world must automatically force a series of equally sharp adjustments elsewhere…

This need to balance implies that the problems in Europe are going to make international trade relations, and especially those between China and its largest trading partners, much tenser. In fact I worry that the sudden and unpredicted speed of the European adjustment will force a resolution of the global imbalances at a far faster pace than I, already pessimistic, was expecting.

…is there anything that China can do to head off conflict?  Yes.  It can buy euros, the more the better – just lift every offer out there. By strengthening the euro, or at least limiting its weakness, this strategy will force the brunt of the adjustment back onto European surplus countries rather than onto the US and, via the US, back onto China.  Sarkozy and other European leaders might not be very happy, of course, but they will be at least partially mollified by the net capital inflows and the reduced humiliation of a collapsing euro.

Interesting. Definitely some food for thought. And I encourage you to read his post in its entirety. But still, I can’t help but wonder whether the political will is there to follow through on such a strategy. My hunch is that policymakers will resist change until forced…

When it comes to the heavily-debated topic of yuan revaluation, I am in the camp that believes the yuan is undervalued overvalued and ought to be revalued. That said however, I have advocated caution with respect to how soon and how fast such an appreciation should take place. My main concern revolves not only around the impact of a yuan revaluation on the Chinese economy, but also its knock-on effects to the U.S. economy (see China and the Revaluation of the Yuan and Yuan Again).

In the former post I opined:

Think about the short-term shock to the Chinese economy, which depends upon exports for a good portion of its GDP. By many accounts, exports make up some 25% of Chinese GDP. A revaluation of the yuan makes Chinese exports relatively more expensive thereby decreasing foreign demand for Chinese-made goods. This negatively impacts local production and creates a feedback loop through to domestic employment and wages. In the extreme, this threatens social stability, and China is certainly not the poster-child for social stability.

Not only that, but given the foreign interests and investments in China, it is not entirely clear to me that a yuan revaluation that catapults China into recession would not result in a global contagion effect. Supply chains are so interconnected around the globe that an upward price movement for intermediate and finished goods coming out of China could have dire consequences for Western companies that rely on Chinese-sourced goods (just ask Wal*Mart).

In the latter post I added:

…the near term economic adjustments associated with a significant rise in the value of the yuan could be painful, not just for China, but for the rest of the world as well. In addition, a sudden rise of the Yuan could be socially destabilizing for China. Given China’s already tenuous political and social situation, it is therefore difficult from a policy standpoint for Chinese politicians to justify…

So basically, China has made a commitment to a production-based, export-oriented economy. Although it certainly is in the long-term interest of China to rely less on domestic investment and exports while encouraging domestic consumption, such an adjustment takes time and there are adjustment pains associated with such a shift. Similarly, any shift of the US economy from one that relies on consumption to one that is centered around production would likewise take time and require some painful adjustments.

I was therefore not surprised to see a recent article summarizing the stance of Justin Yifu Lin (chief economist of the World Bank) with regard to a yuan revaluation. He echoes the sentiment I expressed, and details the nature of some of those “painful” adjustments (see Revaluation Would Hurt U.S.).

The chief economist for the World Bank said on Saturday that if China were to revalue its currency it would actually hurt rather than help the U.S. economy.

He acknowledged that if China stopped selling renminbi and buying foreign currencies, the policy that critics say keeps the currency artificially undervalued, Chinese exports would become more expensive.

But he said because most of the products China exports to the United States are labor-intensive goods U.S. manufacturers stopped making years ago, the U.S. would only have two choices: buy the products from other countries or from the Chinese.

Either way, Lin said, the cost of those goods would rise for U.S. consumers and that would depress both consumer spending and job creation in the United States.

So again, although I agree that China needs to address the yuan-dollar peg, a gradual revaluation to competitive levels is probably the best outcome for the global economy. A sudden rise in the value of the yuan could come with painful near-term adjustments that derail the currently fragile global recovery.

But that said, there’s now an additional complicating factor: With the euro depreciating against both the dollar and the yuan, any plans that Chinese policymakers may have had to revalue the yuan against the dollar are likely to be put on hold (see Europe’s Debt Crisis Casts Shadow Over China).

The pain of the European debt crisis is spreading as the plummeting euro makes Chinese companies less competitive in Europe, their largest market, and complicates any move to break the Chinese currency’s peg to the dollar.

…in light of the euro’s nose dive, such a move could be difficult. Letting the renminbi rise against the dollar would also mean a further increase in the renminbi’s value against the euro, creating even more problems for Chinese exporters to Europe.

Some Chinese companies are already running into difficulty because of the euro’s fall against the renminbi.

“We have been receiving calls from some European clients who signed contracts with us earlier this month, and they all want to cancel their orders, since the depreciation of the euro has eroded all their margins and then some,” said Elvin Xu, the sales manager of Guangdong Ouyi Electrical Appliance in Zhongshan, China, which makes gas stoves, heaters and water heaters.

“They say they cannot increase the prices at their end to their customers, given intense competition in their marketplace,” Mr. Xu added.

In an example of just how interconnected the global economy has become, it is not just Chinese exporters that are adversely impacted by the weakness in the euro, but U.S. exporters as well.

Because American companies in particular compete in the Chinese market with European companies in many industries, the euro’s weakness against the renminbi is putting American companies at a disadvantage.

And the effects are not limited to China.

Euro weakness (dollar strength) lowers the overall profitability of American multinational corporations. It lowers profitability through the repatriation channel (each 1€ of profitability is now the equivalent of only $1.23 in profit). It also reduces the profitability of American exporters as U.S. exports become more expensive in European markets reducing demand for U.S. goods. And it makes it more difficult for American companies to compete with European companies not just in China, but in export markets worldwide as European products become relatively cheaper.

So the problems in Europe that some pundits believe are now largely contained can have serious consequences for global economic growth. And as the New York Times article rightly concludes:

…even China — the world’s fastest-growing major economy and increasingly the engine of global growth — is not immune to the crisis that started in Greece…