Location: New York
Author: Mark Sunshine
Date: Thursday, February 5, 2009
There is mounting evidence that a freely floating Chinese currency will actually drop in value and make Chinese exports cheaper. In his confirmation hearings, Tim Geithner espoused the U.S. “Conventional Wisdom” that China is an unfair trade competitor because it manipulates its currency down in value so that its exports are artificially cheap.
The Conventional Wisdom is that a freely floating Yuan will increase in value making Chinese goods more expensive and helping U.S. manufacturers. But, what if Geithner is wrong and a freely exchangeable Yuan does the opposite of what everyone expects?
Geithner is definitely correct when he says that the Chinese are currency manipulators. After all, the Chinese government decides on Yuan-Dollar exchange rates, and then uses currency controls to ensure that targets are achieved. But, what is unclear is that a freely floating and exchangeable Yuan will increase in value.
The principal evidence supporting Geithner’s view that the Yuan is too cheap is that United States manufacturers have been losing business to Chinese manufacturers for a long time. Economists that support Geithner’s position point to persistent Chinese trade surpluses and conclude that currency manipulation must be taking place.
However, a large current account surplus isn’t in of itself sufficient to cause the Yuan to appreciate. For the Yuan to increase in value, investors and Chinese citizens still must want to own Yuan rather than Dollars, Yen or Euros.
Yuan appreciation advocates ignore underlying economic reasons that make Chinese goods cheap - like near slave wages, cost savings at the expense of the environment, poor worker safety and cheap land. On Sunday, February 1st, the London Times reported
“…a growing number of economists say…that it is not the exchange rate but years of sweatshop wages and income inequality in China that have distorted global competition and stifled domestic demand.”
China critics who accuse the government of being an unfair trade competitor through currency manipulation disregard other facts suggesting China’s currency is overvalued and maybe by a lot.
First, a prerequisite for a strong currency is a strong government that is able to maintain social order. The Sunday London Times article, Violent unrest rocks China as crisis hits, describes labor unrest, riots, state censorship, violence and class warfare The unmistakable conclusion of the London Times article is that the fabric of Chinese society is starting to come apart. The article provides scary and credible details of scores of events that undercut the Western image of an all powerful Chinese government in control of society. The images presented by the London Times don’t provide a social backdrop for China which is a prerequisite for a strong Yuan.
Second, as reported by the New York Times, unemployment is soaring among migrant factory workers that make up the backbone of the Chinese manufacturing workforce. Rising unemployment and a crashing manufacturing sector aren’t typically indicators of a currency that is about to appreciate.
Third, investors have been fleeing China and the flow of export earnings into Yuan has slowed. As reported on February 2nd in the International Herald Tribune
“In Shanghai, cash-rich Chinese companies are buying high-yield bonds of American companies in distress, and bringing home fewer of the dollars they earn abroad from exports.
And in Hong Kong, wealthy Chinese from the mainland are turning up in growing numbers at jewelry stores here seeking one thing: diamonds, big ones…
… Chinese citizens are starting to send more money out of the country and overseas investors are pulling money out of China while slowing their pace of new investments.
China still has torrents of cash pouring in from trade surpluses, as imports shrank faster than exports in the final months of last year. But that inflow has been nearly balanced in recent months by an unexpected outflow of private cash from the mainland and a slowing of investment into the mainland.
Officials… have said conspicuously little about capital flight in recent weeks.”
A sure sign of an overvalued currency is capital flight. When investors, traders and citizens believe that a currency is sound, they do not flee to other currencies, gold, diamonds or U.S. junk bonds.
Fourth, many Sino experts believe that 30 years of currency controls have produced pent up demand in China’s new middle and upper class to invest outside of China. While some exporters and entrepreneurs have figured out ways to avoid government regulations and keep their profits outside of China, for the most part, foreign earnings have been brought back to China and converted into Yuan. However, if exporters were no longer compelled to convert their earnings to Yuan, and were allowed to freely invest outside of China, the floodgates would open and pent-up liquidity would pour out of China and into other currencies. And, the Yuan would depreciate in value.
Finally, Reuters reported on February 2nd that a Central Military Commission was convened and determined that there was “slack management” in some of the ranks of the People’s Liberation Army (”PLA”) and that “…[all] military forces should ensure that they “uncompromisingly obey the Party and Central Military Commission’s command at any time and under any circumstances”. The Commission was convened because China faces “…growing unrest and …”multiple security threats”". The Commission also called for “absolute obedience to the Communist Party”. The fact that the government needed to convene a military commission to make sure that the PLA obeys its orders is surprising. China has two major centers of power, the Chinese Communist Party and the PLA. The Commission’s statements indicate tension between the two organizations and the possibility of conflict within the Chinese establishment. Strong currencies don’t survive when the Army resists following the orders of civilian authorities.
Tim Geithner better hope he doesn’t get what he wants and that the Chinese don’t make the Yuan freely convertible or its crashing value may be an unwelcome surprise to the U.S. economy.
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