At the heart of the battle being waged between the U.S. and China is China’s insistence on strictly controlling the value of its currency, the yuan, and reinforcing the low value it establishes by buying up on the open market vast reserves of U.S. dollars, against which the yuan’s value is pegged. This currency control gives China a considerable, and most would say unfair, advantage over its trading partners — particularly the U.S. — whose free float currencies are valued by the worldwide markets. Asserting this currency control has resulted in an undervalued yuan that is being used to fuel a rapidly expanding domestic economy in China and a robust export business based on cheaper goods.
There is widespread political pressure on China to allow its currency to float, which would produce a more level playing field in international trading, but the country has resisted that pressure to date. At the same time, the U.S. has considered applying economic pressure, such as trade tariffs on Chinese goods, in an effort to force the issue. Many economists think the currency war is unsustainable and will come to a boiling point within the next two years.
The latest statistics from the People’s Bank of China, the country’s central bank, are that China is holding a whopping $2.4 trillion of foreign reserves and it is this hoarding that has led world economists, and recently President Obama, to lambast China as a currency “manipulator.” The Chinese central bank is buying U.S. dollars and Treasuries to increase the value of the U.S. dollar relative to the Chinese yuan so that products it exports have a competitive edge and are less expensive on world markets.
But the value of those reserves declines when the value of the dollar declines. In fact, the Chinese have complained that Federal Reserve Chairman Ben Bernanke’s recent so-called quantitative easing program, which printed more dollars, was a move to purposely force China’s reserves to decrease in value. The fact is that the best way for China to eliminate its reliance on the dollar is to give up control of its currency and allow it to become a free float, free market currency.
“We could see China move toward greater currency freedom in the next couple of years,” says Simon Derrick, currency strategist at Bank of New York Mellon. “It’s all very dependent on how 2011 plays out, of course, but I wouldn’t be surprised to see a move of some kind by the start of 2013.”
But its concern about a declining dollar isn’t the only pressing problem for China — its domestic inflation is now front and center. While its undervalued currency in recent years led to more manufacturing jobs, huge income and property growth, and an expanding export market, it also resulted in inflated prices for basic-need products, like food. In the last six months of 2010, Chinese currency grew about 5 percent.
To counteract that inflation, the Chinese central bank took the rare step in 2010 of raising interest rates for the first time in three years. Most recently, with a splashy announcement on Christmas day, the bank upped the lending rate 25 basis points, the second time in two months, so that the benchmark now sits at 5.81 percent. But this move made the yuan even more attractive to foreign investors, particularly pension funds, because the deposit rate was increased to 2.75 percent. In response, these foreign investors have been depositing this so-called “hot money” into Chinese banks. The problem with this new influx of capital is that investors who can pump money in quickly also can pull out lighting fast once the yuan stops increasing in value. That could crash the Chinese stock market if withdrawal is not paced right. It is another reason the Chinese government needs to have U.S. dollars in reserve — to prop up the yuan when investors start pulling out.
A currency trader, who asked to remain anonymous because his fund’s investment decisions are private, said, “Continued rate hikes and a move toward managing a floating currency should be major themes for the next year or two as China continues to try to rein in food and property inflation, the two most obvious threats facing the country at present.”
But other investment professionals think the China mind-set is nowhere near a democratic economic regime that would let the yuan float freely. As a result, some market pundits are predicting that China’s economy could face a “very hard landing” in the next year.
Doomsday List
Michael Shedlock, investment advisor at Sitka Pacific Capital Management, based in Sonoma, California, recently sent his clients a doomsday list, detailing why China’s economy could be destined for that hard landing. He points out traders are now betting the yuan will go up by 6 percent in 2011, but he thinks that is a steep estimate that involves considerable risk. Other countries have restricted the inflow of foreign capital in order to prevent further inflation of their currencies — but not China. And because of that worry, Shedlock doesn’t think the People’s Bank of China can move to a free float.
“After the hot money is out, China will be in a better position to stop worrying about capital fluctuation and, at that point, it could maybe consider a free float exchange,” says Shedlock. “But even then, with the other economic bubbles that exist in the country, like the overbuilt — and largely vacant — property market, the Chinese won’t be giving up control of their currency any time soon.”
Not giving up control means the yuan stays undervalued. An undervalued currency means cheap manufacturing jobs stay in China and top U.S. companies keep paying China to make products that could be produced here. The undervaluation is so much of a concern that U.S. Senator Sherrod Brown (D-OH) and U.S. Senator Olympia Snow (R-ME) tried to sneak in an amendment to the 2010 tax bill that would have forced the U.S. Treasury and President Obama to make a tactical battle move on China, specifically by imposing trade tariffs on its exports. Currently, only Timothy Geithner, head of the U.S. Treasury, has the power to make a move like that.
The senators’ proposed amendment failed to pass. In January, Senator Charles Schumer (D-NY) proposed an even stronger bill that would enable Geithner’s office to impose tariffs without having to prove China’s intent to manipulate their currency. Of course, trade sanctions against the Chinese, like those Obama imposed two years ago on Chinese-made tires, run the risk of the Chinese imposing similar sanctions against critical U.S. exports, such as agricultural products. Such a tax could double the price of U.S. food products sold to Chinese consumers, like the popular American-produced chicken, and drive China’s 1.3 billion consumers to buy domestic. Such a tariff actually did threaten the U.S. poultry business in September 2009. The punitive tariff was eventually lifted and then brought back at higher rates in September 2010. So, while Senator Brown’s blue-collar manufacturing sector is hopeful that a tariff would return manufacturing jobs to the U.S., the agricultural sector in other states doesn’t want to see chicken farmers put out of work.
Not A Level Field
At the beginning of 2011, Martin Feldstein, Harvard economics professor and chairman of former President Reagan’s Council of Economic Advisers, spoke about the U.S.-China account imbalances. Feldstein thinks American goods can become more competitive relative to Chinese goods if the nominal value of the dollar falls relative to the yuan. But this clearly isn’t happening. “Since the Chinese price level has been rising at about 5 percent while the U.S. inflation rate has been only about 1 percent, the difference in inflation rates adds an additional 4 percent to the change of the real exchange rate. The combination implies that the real value of the yuan relative to the dollar is rising at about a 9 percent annual rate.”
“You can see that the playing field isn’t level right now,” says Derrick. “A Japanese government official recently pointed out that China can meddle in other countries’ currencies but no one can meddle in its currency because it’s controlled.” Derrick is of the opinion that the People’s Bank of China actually wants to have the currency float, but China’s Commerce Department wants to protect the cheap manufacturing business that allows them to compete at a top level in the world markets.
The U.S. and China have talked policy changes, including a change in China’s exchange rate policy, but Feldstein thinks that Obama’s team has focused too much attention on the exchange rate rather than on the saving and investing practices of China’s consumers. “They did not succeed in changing those polices and may have caused China to resist an exchange rate adjustment more strongly to avoid the impression that China was forced by the U.S. to alter its policy,” says Feldstein.
Save or Spend
According to Eric Jackson, founder of Ironfire Capital, a hedge fund investment firm based in Naples, Florida, which focuses on China-based companies, “The yuan will go higher. And the uncertainty of how the Chinese government will manage the currency has made the older generation afraid to invest in stocks or put all its money in Chinese banks.” With so much money being made, this distrust of banks and the stock market has led Chinese consumers either to try to diversify their investments, even into luxury goods, or to hold on to their money. In fact, Jackson says he knows of one entrepreneur who rented a 1,000-square-foot apartment just to store his newly earned cash.
“People are getting richer much more quickly and the market is watching to see if the Chinese will save or spend their yuan,” says Jackson. As a result of the currency wars, he sees the Chinese still wanting to own hard assets, like diamonds. But if the yuan really does significantly increase, then the gains some are expecting when they sell their hard assets will not be as great.
Barry Ritholtz, a former-lawyer-turned-economist-pundit and founder of “The Big Picture,” an economic/investment blog, doesn’t see a free float Chinese currency happening. He thinks the political appeal of all those cheap manufacturing jobs China can offer its citizens, combined with the money made on exports, outweigh the current losses China’s central bank is incurring by owning so many depressed U.S. dollars.
In mid-January, Pharo Management, a $4 billion London-based fund, became the first hedge fund manager to offer shares in an investment fund dominated by the yuan. At the same time, the Chinese government ruled that domestic companies could move the renminbi offshore for investment purposes, this making it accessible to a wider audience. Both moves confirm the appeal of Chinese currency to global investors and, at the same time, their concern about the strength of the dollar.
The currency war is now a wait-and-see game. Will China fold to international pressure and relinquish its control and liberalize its currency, allowing it to float freely, which would help level out the international playing field and ease the U.S trade deficit? Or will China keep fueling a cheap manufacturing economy and find another way to make those depressed dollars they are holding in their reserves pay off down the road? Only time will tell.
Article from the Rapaport Magazine - February 2011. To subscribe click here.