Friday, June 25, 2010

Winners and Losers from the Yuan Re-valuation


China cleverly announced its decision to permit its currency, the yuan, to float more widely and gradually move higher against the dollar shortly before the G-7 and G-20 meetings. It took away the biggest gripe other nations had about it, and leveraged its ability to lecture them about their failings. The Chinese, who are heavily invested in both dollar and Euro denominated assets, have much to say about the profligacy of the West, and much to gain if Western nations get their financial houses in order. The re-valuation was begun just as China is turning to building domestic consumer demand in order to lessen its dependence on exports to the West. It's no accident Chinese authorities didn't interfere when workers at Honda and Toyota plants in China went on strike. Higher wages in China will boost domestic demand. (Henry Ford did something similar in 1914 when he first began paying workers the then astonishing wage of $5 a day.)

China in the long term will win from the re-valuation of the yuan. Its manufacturers will seek to become more efficient and cost effective in order to preserve their export markets. Given China's indisputable prowess in manufacturing, expect many of them to succeed. The same thing happened with Japan. In the early 1970s, the yen traded at over 300 to the dollar. Despite various Japanese government measures to keep the yen down, it rose to the low 200s per dollar by the end of the 1970s. But Japan kept running a trade surplus with the U.S. because its manufacturers continued to improve (and in some cases move their factories to lower cost countries in Asia, but this still helped Japan maintain a surplus with America). In the 1980s, the yen stubbornly remained around the low 200s until a 1985 international agreement called the Plaza Accord led to its devaluation into the low 100s. Nevertheless, Japan's trade surplus with the U.S. remained sizable. It remains sizable to this day (over $44 billion in 2009), even though the yen now trades around 90 to the dollar. Japan's exporters still work hard to improve efficiency and quality. The Chinese will do the same, and their likely success will preserve many export markets. Efficiency improvements will also help them to seize market share in China's growing domestic markets, reducing opportunities for America and other nations to export to China.

Mexico and other low cost manufacturers will also win. America's now chastened consumers, who have rediscovered the virtues of saving, will resist higher prices. As China's prices rise, American retailers will seek out alternative inexpensive sources of supply. These will almost always be in other foreign nations with low labor costs.

Currency traders at big banks, hedge funds and elsewhere will have more opportunities with a more flexible yuan. Traders like volatility, because price movements, whether they are up or down, create larger profit opportunities than stable exchange rates. Big banks will also profit from selling derivatives products to hedge or speculate in the value of the yuan.


The United States could easily end up on the short end of the stick. A higher yuan will improve American industry's ability to export to China. But long term success is far from certain, as Chinese manufacturers will fight back by vigorously improving their capabilities. America's failure to achieve a trade balance with Japan after the yen more than tripled in value over 30 years is sobering. America needs to concentrate its resources on developing products and services other wealthy nations want to buy. Its last couple of decades of growth have been financed by foreigners purchasing American debt, and that's a trend that won't last. A big recent American innovation, social networking sites, may be fun, and popular overseas as well as here. But these sites are not noticeably profitable, and won't add much to our national income. Investment in basic research and development, bio tech and high tech should be favored. We don't need more financial engineering. We need more science-based engineering. Long term economic growth can't rest on the hoped-for continued escalation of real estate or any other asset. It should come from making things other people want to buy.

EU nations are also likely losers. The still unfolding sovereign debt crisis reveals that Western Europe, like America, used debt instead of productive capability to foster "prosperity." Europe is less innovative than America, and its prospects for growth are correspondingly lower. (EU per capita income is already about 30% lower than America's and Europeans should worry about whether or not that comparison will worsen.) As the rising yuan strengthens China, and American industry seeks to riposte, Europe will be caught in the cross-fire. Germany, with its famed discipline, might maintain relative parity. But the rest of Europe may have to rely increasingly on the quaintness of its tourist sites to pay the bills.

Political Winners

While we've been focusing on economics, the yuan re-valuation eases tensions between America and China, and makes it easier for them to work together on common problems. China wants to become wealthier and stronger. But it would not want America to become weaker. America is the world's police officer, and is taking the brunt of the load of dealing with international nut cases like North Korea's Communist government and the radicals in power in Iran. If the U.S. were to weaken and reduce its level of engagement in Asia, China would be stuck with a lot of nasty problems. The Chinese benefit economically from a prosperous South Korea, so they'd have the primary burden of constraining the loonies in Pyongyang, a job now largely performed by the U.S. troops on the 38th parallel. The Chinese would also have to greatly increase their involvement in the Middle East, a crucial source of petroleum for them and many of their Asian trading partners. The U.S., at great cost in lives and money, currently ensures a steady outflow of oil from the Middle East. And the U.S. war against Islamic radicalism in Afghanistan and elsewhere suits China's purposes. The same radicalism has seeped into the Muslim populations of Chinese Central Asia, creating unrest and occasional violence. The Chinese know they would become a primary target if America withdrew from the field of fire. America, in turn, needs China's cooperation with its many problems in Asia and elsewhere. Thus, both nations are political winners from the yuan re-valuation.

No comments: