Renminbi redux.

The Chinese finally decided to let their currency, the renminbi (or yuan), “float” against the U.S. dollar. (For background, please see my prior post: Renminbi revaluation). I put the word float in quotes because it will be highly controlled and not a float in the free market sense.

Political leaders the world over, but especially in the U.S., have been pushing for this revaluation for some time. I doubt it will generate the outcome such leaders hope for. My expectation is higher interest rates and commodity prices in the long run that will eventually make our problems here and abroad worse instead of better.

An interesting question to ask, then, is: why did the Chinese finally do what everyone wanted them to do?

The most obvious answer, and the one that will satisfy most political leaders, is that China bowed to U.S. or international pressure. I doubt that’s the case. Right now the rest of the world depends on China as much as or more so than the other way around.

Another suggestion, mostly from political thinkers, is that China is assuming its position on the world stage and having an independent currency is part of that. Although more feasible than caving to pressure, I think this argument misses the mark, too. I believe China desires a prominent position in the world, but I don’t think it would sacrifice a piece of its low cost edge in order to get it.

No, I think the real reason behind revaluation is inflation in China.

In fighting financial problems over the last decade, the U.S. Federal Reserve has printed a lot of dollars. That printing has led to higher prices, especially for food and the key inputs to production (copper, iron ore, oil, etc.).

This impacts first world countries much less than third world countries. The first world spends somewhere around 20% of their income on such things as food. The third world, including China, however, spends much closer to 60%.

When the price of an apple doubles and it’s less than 20% of your income, you complain a bit, but it doesn’t cause a significant problem.

When the price of food doubles and it’s 60% of your income, you riot in the streets.

That’s the situation I think China is facing. They’d like to keep their currency on par with the dollar to maintain their low cost competitive advantage (with significant margin to spare), but not at the expense of having inflation cripple its poorest people.

I believe China’s goal is to grow to first world standards of living without causing a revolution. That’s a very delicate goal to achieve, especially with centralized planning and in the short time period they want to achieve it.

They won’t get there if their economy slows too much, or if they have high inflation.

I don’t think China is caving to pressure from the west or seeking the prestige of an independent currency. I believe they are walking a tight rope, and inflationary threats were making them lean way too far in one direction.

Revaluation, for them, is a practical economic matter, not purely a political one.

Nothing in this blog should be considered investment, financial, tax, or legal advice. The opinions, estimates and projections contained herein are subject to change without notice. Information throughout this blog has been obtained from sources believed to be accurate and reliable, but such accuracy cannot be guaranteed.

Renminbi revaluation.

Be careful what you wish for, you just might get it.

The U.S. Congress has been trying to get the Chinese to allow their currency, the renminbi (or yuan), to appreciate versus the U.S. dollar. Timothy Geithner, our Treasury Secretary, rushed off to the far east to broker such a deal a couple of days ago.

Whereas most see this as a wonderful beginning, I believe it will end in tears.

Chinese currency is called renminbi. The word means “people’s currency” (in direct contradiction of those who believe China has anything to do with capitalism). It’s more commonly and historically called the yuan (which means round, after the shape of coins).

The Chinese peg their currency to the dollar. This means they buy and sell dollars and yuan to keep the 2 currencies marching in lockstep. The yuan was pegged to the dollar from 1997-2005 at 8.27 yuan to the dollar. It was allowed to float somewhat freely (“managed peg”) from 2005 to 2008, where it appreciated (in a very controlled manner) from 8.27 to 6.83 (fewer yuan to dollars means the yuan is going up in value). That managed peg lasted until the crisis of 2008, when it was put back on a fixed peg at 6.83 yuan to the dollar, and remains there still.

The Chinese are not mean-spirited in pegging their currency. They partially do it to maintain their trading relationship to the U.S. It’s easier to conduct trade, both for people in the U.S. and China, when you know what the exchange rate will be. They also peg their currency because they are a controlled economy. In other words, they don’t have the mechanisms to let their economy manage itself because it’s not a free market.

Many think this gives China an unfair advantage (sarcastic comment: just like it gives Alabama an unfair advantage over Michigan to have the dollar in Alabama the same as the dollar in Michigan). Such folks believe we must force China to remove its peg so we can compete more “fairly” (unless, of course, the people in Congress think they are losing, then they don’t want it to be fair).

I don’t believe forcing China to revalue its currency will be all good news.

It will be good for U.S. companies who compete with China. If Chinese and U.S. companies are competing for the same business, China has an advantage by manipulating its currency. But, China does not compete with the U.S. for high-end manufacturing, they compete with the U.S. at the low end, mostly. So, it will benefit low-end manufacturing in the U.S.

But, this will be bad for U.S. consumers. Letting the yuan appreciate will make all those Chinese goods we buy cost more (and we buy a LOT of Chinese goods). It also means China will have a more valuable currency to compete with U.S. dollars in buying goods all over the globe. In other words, it will lead to higher prices for commodities, goods, probably everything.

A small minority of U.S. businesses, with buddies in the Congress, will benefit at the expense of the vast majority of U.S. consumers and higher-end U.S. businesses. Isn’t that nice.

The fallout will not be pretty, to be frank. It’s bad for bonds because it means higher interest rates. And, those higher rates will hit U.S. consumers, U.S. businesses, and, of course, the biggest debtor of all: the U.S. government.

It will be good for commodity investments. It will be good for U.S. businesses in competition with Chinese businesses. That seems like more downside than upside to me.

To top it off, it won’t solve the U.S.’s fiscal problems–it will make them worse. Higher interest rates and inflation will not reduce the U.S.’s debt, or reduce our burden of future social programs. Nor will it help employment. For every new job in low end manufacturing, we’ll lose 2 or more elsewhere. It will lead to larger public finance problems, and sooner.

The U.S.’s problem is that it spends too much and it pays with debt. That’s not China’s fault. We need to save more, spend less, and make products that others want. We won’t beat China with low-end manufacturing, but we can at the high-end. But, a depreciating dollar relative to an appreciating yuan won’t help that.

No, getting the Chinese to allow the yuan to appreciate will not help the U.S., it will help China. Is that what we really want?

Nothing in this blog should be considered investment, financial, tax, or legal advice. The opinions, estimates and projections contained herein are subject to change without notice. Information throughout this blog has been obtained from sources believed to be accurate and reliable, but such accuracy cannot be guaranteed.

As fragile as China.

As I’ve remarked before (here and here), much of the current worldwide economic recovery is due to China. For that reason, the greatest sensitivity to continued recovery is what happens in and with respect to China.

This recovery is as fragile as China (meaning delicate plates as well as the country).

Demand from China has driven up commodity prices and kept production flowing from manufacturing-based economies. For evidence, look no further than companies like Caterpillar and the land-office business they are doing in the far east.

If something were to go wrong in China, the economic impacts would reverberate throughout the global economy.

What could go wrong? If you haven’t noticed, there have been a lot of political issues surfacing between China and the U.S.

This includes the U.S.’s desire for China to allow it’s currency, the yuan/renminbi, to appreciate. This would make U.S. manufacturers more competitive with China. China has no interest in making itself less competitive, so this creates a lot of tension between the U.S. and China.

And then, there’s the spat between Google and China over censorship and hacking. It shows the inherent conflicts that exist between a command and control government like China’s and free market enterprises like Google.

Of course, there’s also the Dalai Lama. He represents the Tibetan government in exile and China doesn’t like his concerns being heard by the most powerful nation in the world. President Obama met with the Dalai Lama this week, infuriating China.

Then, there’s also our insistence on selling high-end weapons to Taiwan, whom China considers to be an errant state. It would be like Russia selling arms to Alaska, with Alaska being quite clear it would like to secede from the union.

So, there are a lot of political issues going on between the U.S. and China, not to mention they hold a ton of U.S. national debt. It’s a touchy situation.

China, too, has its own internal problems. Approximately 700 million people live in poverty in the Chinese interior while another 600 million are growing rapidly nearer the coast. Growth and trade has been great to the 600 million and less so to the 700 million. That is why some 20 million Chinese, a year, are moving from the hinterland to the coast looking for work.

This dynamic means that China simply can’t let growth slow too much. If it does, they will have a revolution in short order. Such is the history of China over the last…oh…2,000 years.

China is an island, geopolitically, and it has repeatedly cycled between external growth/interaction and internal strife/revolution. Until they change their political system from centralized command and control, as it’s been for 2 millennia, this external/internal cycle will continue.

This internal dynamic is the main reason why China won’t let its currency appreciate, and why they are working so hard to stimulate worldwide growth. China needs worldwide growth because they need someone to sell their low cost goods to.

The problem is that political tensions with large economies like the U.S., Europe and Japan are all working against this process. And, of course, the U.S., Europe and Japan all have major internal issues of their own that make them less than conciliatory towards China.

With all that on the table, how long until we see Chinese fragility? I don’t know, and neither does anyone else. But, it’s reasonable to assume the game can go on for several more years.

If China plays their cards right, then perhaps they can keep the game going long enough for the rest of the world to work out its problems and start growing again on its own.

If they slip up, though, which seems highly likely over the next five years, then that fragility could crack the delicate plate and lead to worldwide consequences.

We’d all like to see China succeed. If they do, then the world economy gets bailed out of its experiment with too much leverage. If not, it could lead to another major economic upheaval.

For now, expect China to keep the game in play. It should be good for stronger economic growth than most are forecasting. But, when the end-game arrives, it won’t be pretty.

Nothing in this blog should be considered investment, financial, tax, or legal advice. The opinions, estimates and projections contained herein are subject to change without notice. Information throughout this blog has been obtained from sources believed to be accurate and reliable, but such accuracy cannot be guaranteed.