Monday, November 23, 2009

Should The US Really Desire A Strong Yuan

The yuan has basically rise by 20% over the last 12 months against the USD. Still, many have been calling for a dismantling of the yuan's peg. The peg, they argue, offers China a competitive advantage by making its products cheaper in U.S. markets, thus allowing Chinese firms to gobble up market share and steal jobs from U.S. manufacturers. The thought is that were China to allow its currency to rise, American manufactures would regain their lost edge, and both manufacturing firms and the jobs formerly associated with them would return. Well, that is the partial truth - the fact is the majority of China's exports are actually US products, owned by US companies manufacturing in China, then exporting it to other countries. China's voracious export machinery is due in part to the foreign investments, or better known as outsourcing. If it wasn't China, it would India, or some other Asian country or Latam country. That argument does not hold water.

One can also argue that the outsourcing movement has allowed many companies in the US and Europe to "save on costs" and hence report sustainable margins growth. To allow for a free floating yuan, say gaining another 30% against the USD over the next 12 months, could see those cost savings being shaved considerably. It won't help the US much as the companies will just look to produce the same goods and/or services somewhere else cheaper. It will be a long time before they say, let's go back and do this in the US, not when your basic manufacturing labour cost between $15-30 an hour.

While the peg certainly is responsible for much of the world's problems, its abandonment would cause severe hardship in the United States. The US economy is very dependent on life support provided by an endless flow of debt financing from China. These purchases are the means by which China maintains the relative value of its currency against the dollar. As the dollar comes under even more downward pressure, China's purchases must increase to keep the renminbi from rising. By maintaining the peg, China enables the US to continue spending more than they have and avoiding the hard choices necessary to restore the US long-term economic health. Conversely, a much stronger renminbi may actually result in China purchasing a lot less Treasuries as their surpluses figure would start dwindling down - so who is going to fund the US printing press when that happens?

Contrary to the conventional wisdom, when China drops the peg, the immediate benefits will flow to the Chinese, not to Americans. Yes, prices for Chinese goods will rise in the United States - but so will prices for domestic goods. As a corollary, the Chinese will see falling prices across the board. As anyone who has ever been shopping can explain, low prices are a good thing. In addition, credit will expand in China while it contracts in the US. As demand falls for both dollars and Treasuries, prices and interest rates in the United States will rise. Rising rates will restrict the flow of credit that is currently financing government and consumer spending. This change will finally force a long overdue decline in borrowing. Which is not really a bad thing, but it could derail the jobs outlook in the US for a prolonged period - a move that can be deem as political suicide at this point in time, and considering where we are following the financial crisis.

On the flip side, in the long run, the US economy will benefit from the abandonment of a system that guarantees our dependency and inevitable downfall. De-pegging will force the hand of US politicians toward pursuing realistic policies. The Chinese will come to their senses eventually because it is in their interest to do so. Meanwhile, the longer the peg is maintained, the more indebted the US become, and the more their industrial base shrivels. In short, the longer they wait, the steeper the fall for the US.

If Wal-Mart were a country it would be China's eighth-largest trading partner. Some 70% of the products sold in Wal-Mart have Chinese components. Billions of dollars of purchasing power would be taken from American consumers if the renminbi were to appreciate. While China's economy enjoyed 8.9% growth in the gross domestic product in the third quarter of this year, the country's continued economic strength is not guaranteed if the American consumer stays in a funk.

A fact not appreciated by many observers is that China is no longer an export-led economy. It is still important but not as big as perceived, exports still account for 20% of its economy. Already 10,000 factories have shut in export hubs like Guangdong. The ones that remain often exist on paper-thin margins of 2% to 3%. Even a small currency appreciation would cause thousands more factories to shut and leave millions more unemployed. That is something Beijing will not allow to happen.

The biggest currency problem in the world is not a weak yuan but a weak dollar. That is the issue President Obama should focus on. Foreign governments hold the dollar in vast quantities because it has been seen as stable. China and Japan alone hold over $3 trillion worth. As the dollar plummets, many nations are abandoning it, fearing further erosion in their portfolios. They have done so as quickly as possible but carefully as well, knowing that if they move too fast the dollar will fall even faster.

Rather than wasting time pushing China to strengthen the yuan, Obama and the Fed should figure out how to strengthen the dollar by paying down the US debts. A strong dollar, not a strong yuan, is the right debate.

p/s photo: Yang Mi

1 comment:

Gamelion said...

The US has to face the reality that they r at the mercy of China. It would be a really an unwise/foolish act to use the necessary tools to force the China to strengthen the Yuan by dumping a large amount of US$ . This really (unlike the US bankers) will bring the systemic risk that will cause an economic collapse to US.