Is this the end for a slightly odd couple?

The close economic relationship between America and China that has emerged in recent years has been described as “a marriage of convenience”. In effect China has agreed to prop up the American economy, by buying treasury bonds, in return for US consumers purchasing its goods. The breakdown of the renminbi-dollar peg (see page 5) could be the first stage in the break-up of that relationship.

In fact, the US-China relationship is more like a couple living together than a marriage. There is no official agreement between the two sides on cooperation. Rather, circumstances have favoured the development of close ties. America is consuming more than it is producing – so it has to borrow from abroad to maintain its current lifestyle. At the same time China, despite having a population of 1.3 billion, has limited domestic demand so it has to export much of its output.

The revaluation of the renminbi has come about through America saying, in effect, that the slightly odd couple should spend more time apart. America has led a concerted campaign for China to revalue its currency on the grounds that it is competing unfairly with American producers. At least part of the Bush administration’s motivation seems to have been to head off even more protectionist measures being proposed by American politicians (see Fund Strategy, July 4, 2005, page 12).

From a disinterested perspective America’s initiative was highly ungrateful. In effect a poor – although rapidly growing – country was subsidising the richest country in the world. Yet America wanted still more from the deal. It seemed to desire the benefits of cheap imports from China without Chinese firms undercutting US producers in any area.

In the medium term America could regret what it has wished for. It has benefited enormously from Chinese backing – even though this has arguably postponed a necessary US economic readjustment. Now it has created a situation where China has less incentive to support the American currency and ultimately the US economy.

No doubt the odd couple is likely to muddle through in the short term. The initial revaluation of the renminbi against the dollar is relatively small. And the two sides still have a strong mutual interest in cooperating.

Yet America has probably inadvertently started the process of break-up between the two sides. It will become easier for China to diversify its foreign exchange reserves from dollars into euros, yen and other currencies. If China does make such a move it will become harder for America to consume so much more than it produces – in other words, America will have to reduce its current account deficit.

The saga of the US-China relationship has only just begun.