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After the talks between US President Barack Obama and Chinese President Hu Jintao last November, the US and China agreed to work hand in hand to help bring the world out of recession. They promised to fix the imbalance between the saving methods of East (Asian) nations and the shopaholic ways of the West.

The tension surrounding this issue has been heating up between the two nations because of their economic and political relationship. While China holds the greatest amount of dollar reserves in the world, it has expressed concern regarding the stability of the dollar. Chinese officials have even suggested that they might diversify some of their reserves away from the dollar!

In their frustration with China’s stubbornness, the US broke the silence and took concrete steps to address this issue. A few days ago, US President Obama called for China to adopt a market-oriented exchange rate policy by removing the Yuan’s peg to the US dollar and allowing it to appreciate freely.

China retaliated the very next day as People’s Bank of China Vice Governor Su Ning defended their current exchange rate policy, denying that the Yuan is deliberately undervalued to spur China’s export growth. On top of that, he also said China doesn’t agree with a country taking its problems and having another country solve them. Oh snap!

Of course, Uncle Sam isn’t going to back down without a fight, right? This week, several members of the US Congress urged President Obama to brand China as a ‘currency manipulator.’ Lawmakers even proposed a bill which would empower the US administration to take more proactive measures in rebalancing exchange rates. This legislation could allow the US government to impose trade restrictions on Chinese products unless China gives in to US demands.

Despite the threat, China refuses to budge and this defiance could be both politically and economically motivated. Remember that China’s economy has been chugging along like a Panzer tank, and is on track to surpass Japan as the second largest economy in 2009. Being one of the new top dogs, it would not simply allow the US to dictate and bully them around.

On the economic front, China reasoned that a currency rebalancing as suggested by the US would greatly hit its exports, possibly leading to a double dip recession in the Chinese economy. Such a scenario would cause a ruckus not only in the Chinese market but everywhere else, especially in the emerging economies. Now, no one wants that, right?

On the Western front, the US and some European nations argue that China’s policy to peg its currency on the dollar is crowding out the exports of the other countries, causing huge trade deficits in their economies. This happens because of the low value of the Yuan, which makes Chinese exports cheaper and more attractive. The road to a global recovery could take a longer time if this issue is not addressed properly.

Now that China has openly stated that it does not have any plans on changing its stance, I’m afraid to say that the dispute between the two may only get worse. The US could hit China back by imposing an across-the-board tariff on Chinese products. China, on the other hand, could retaliate by dumping some of its US debt holdings. So much for trying to fix the global imbalance side by side!

With temperatures rising between these two superpowers, the situation could escalate into a full-grown trade war, which would have serious effects on the global economy.

Remember, since 2003, China has been buying up large quantities of US dollars to make sure that the value of the Yuan remains low versus the dollar. All in all, it has built up as much as $2.4 trillion dollars in reserve, which equates to more than half the total volume that passes through the entire $4 trillion dollar forex market!

As unlikely as it might sound, if China decides to “un-peg” its currency and starts dumping its US reserves back into the markets, we could see a massive drop in the dollar’s value which would disrupt the flow of global trade.

From another perspective, this move could open the doors for a more balanced global trade environment. Countries in the West, particularly the US, would be encouraged to start stimulating their export industry instead of simply taking in all of China’s imports. Although growth in China would tick down a bit, it would give the chance for the Western nations to boost internal consumption for its domestic products and reduce their deficits.

Still, I think the Yuan’s exchange rate is just a part of the equation in solving the problem of global trade imbalances. It’s going to take more than tightening a few loose screws to fix the mess the world got itself into! With that, I need to find a way to get my hands on that iPad sooner rather than later…