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Why China Manipulates the Yuan

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The United States and China are locked in battle over China's manipulation of its currency. The yuan's undervaluation has become so considerable that economists now blame it for stifling the economic recovery and pushing us into a liquidity trap. Nobel laureate Paul Krugman has even urged the Treasury Department to formally label China a currency manipulator so the U.S. could then institute tariffs and other trade barriers without running afoul of the World Trade Organization.

Because China isn't likely to abandon this policy anytime soon, the tensions between our countries are bound to escalate. A recent book titled Currency Wars even reported that the Defense Department has collaborated with financial experts to simulate a full-blown currency war. Whether this will come to fruition is anybody's guess, though it isn't outside the range of possibilities.

Why China manipulates its currency
While Americans associate 2001 with the al-Qaeda attacks on the East Coast, most Chinese are likely to recall it for a very different reason. That was the year China gained admission to the WTO after a decade and a half of negotiations.

The WTO was established to supervise and liberalize international trade. On one hand, it prohibits a country from directly subsidizing its export industry to the detriment of the industry's foreign competitors. And on the other, it protects countries that play by the rules from unilateral trade sanctions imposed by a fellow member.

What's notable about the WTO from China's perspective is that, unlike the International Monetary Fund, the WTO doesn't prohibit a country from indirectly subsidizing its exports through currency manipulation. If a member was so inclined, it could accordingly have its so-called cake and eat it too. In other words, it could subsidize exports by keeping its currency artificially cheap, while at the same time seek shelter from retaliation under the WTO's proscription against trade sanctions.

And this is exactly what China has done. As you can see in Chart 1, it has systematically devalued the price of the yuan over the last 30 years. In 1980, $1 bought 1.71 yuan. By 1995, $1 bought 8.37 yuan. (Note: The exchange rate in the chart is inverted to achieve a negative slope.) An 80% decrease in value! This has bolstered its export industries by making Chinese manufactured goods artificially competitive in the global marketplace. And by doing so, it has markedly contributed to the phenomenal growth in the country's gross domestic product.

Sources: Federal Reserve Bank of St. Louis, World Bank, and author's calculations.

How China manipulates its currency
The foreign exchange market and currency values can appear imposing and abstract. Yet currency is simply a commodity. Its value is set by supply and demand. The higher the supply of a currency relative to demand, the lower the value. And vice versa.

So if China wanted to decrease the value of the yuan relative to the dollar, it would simply increase both the supply of yuan and the demand for dollars by selling the former and buying the latter. A country that does this over time thus accumulates large reserves of foreign currencies. And according to data from the IMF, this is the case with China, as you can see in Chart 2.

Source: Federal Reserve Bank of St. Louis.

China's accumulation of foreign currency reserves is unprecedented. It's gone from just under $4 billion in 1980 to $3.18 trillion today, most of which consists of dollars. This represents an increase of nearly 80,000%! And what does China do with all of its excess dollars? It lends many of them back to our federal government to finance its massive deficits -- $1.1 trillion, to be precise.

The impact of China's currency manipulation
With the preceding discussion in mind, the negative aspects of China's currency manipulation may not seem obvious. We print money, give it to them for their artificially cheap goods, they give it back to us with interest, we print more money to pay the interest, and on, and on. While this has contributed to a significant trade imbalance with China, the cost of our borrowing to finance the deficit has been limited effectively to the cost of printing dollars -- which nowadays we do by pressing a button on a computer.

For many years, a number of economists even believed this cycle was beneficial to the American economy. As late as 2007, a paper was published by the Federal Reserve Bank of Philadelphia, titled "Trade Deficits Aren't as Bad as You Think" (PDF file, Adobe Acrobat required). It argued that trade deficits were good because they "shift worldwide production to its most productive locations, and allow individuals to smooth out their consumption over the business cycle."

Unfortunately, this line of thinking didn't account for the volume of dollars that flooded back into the American economy. These dollars made their way into the housing sector and fueled the then-burgeoning real estate bubble. Federal Reserve Chairman Ben Bernanke calls this his "savings glut" hypothesis. The implication is that we are where we are because of these capital flows. And these capital flows are the natural consequence of China's currency manipulation. In the greatest irony of all, in fact, it's for this reason that China strictly limits capital flows into its economy.

I'm nevertheless bullish on China
While I believe it's likely that China's manipulation of the yuan has contributed to both the depth and duration of the Great Recession, I don't think now is the time for investors to be xenophobic. And particularly with respect to China, as its economic potential is unprecedented and will handily compensate investors for otherwise tepid growth in the Western world.

Given the rampant fraud underlying Chinese stocks, however, I would urge investors against speculating in questionable companies. Two such examples are Internet search giant Qihoo 360 (NYSE: QIHU  ) and China Green Agriculture (NYSE: CGA  ) . Qihoo 360 came under fire last November when Citron Research accused it of overstating its popularity as the third most popular Internet company by user base. And China Green Agriculture has recently come to the attention of short-sellers.

 A much better bet is to go with known entities like Chinese fertilizer maker Yongye (Nasdaq: YONG  ) ; Baidu (NYSE: BIDU  ) , aka "the Google of China"; or Dangdang (NYSE: DANG  ) , aka "the of China." Our own Tim Hanson recommended Yongye after visiting its management and manufacturing plants on multiple occasions. Fellow Fool Brian Stoffel calls Baidu one of his favorite pure plays in China. And Dangdang is one of 2012's best performers thus far.

Our top stock recommendation for 2012
If you remain understandably wary of investing in Chinese companies, check out our recently released free report, "The Motley Fool's Top Stock for 2012." It profiles an up-and-coming retailer that's being billed as "the Costco of Latin America." To learn the identity of this company before the market catches on and bids its price up, click here now -- it's free.

Fool contributor John Maxfield does not own shares in any of the companies mentioned above. The Motley Fool owns shares of Yongye International. Motley Fool newsletter services have recommended buying shares of Baidu, Yongye International, and China Green Agriculture. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.

Read/Post Comments (10) | Recommend This Article (29)

Comments from our Foolish Readers

Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

  • Report this Comment On January 24, 2012, at 10:34 AM, kidchicago2 wrote:

    What a clueless article. You say you like YONG, but not CGA, because CGA (1) has "recently" been targeted by short sellers and (2) "Our own Tim Hansen recommended Yongye after visiting its management and manufacturing plants on multiple occasions."

    On (1), CGA has not been the subject of a short attack in two years. YONG was attacked in a published short report as recently as December 2011. And the volume of short attacks on YONG has been much higher overall. More to the point, short interest in CGA has dropped dramatically over the last year, while the number of shares short YONG have not dropped nearly as much. FInally, the link you provide to support your claim that CGA has "recently" been attacked is just another Fool article written by another of the Fool's non-employee independent contractors. And that article itself does not link to or cite any recent published short attacks on CGA.

    On (2), Tim Hanson also visited CGA's facilities, multiple times. And he also recommended CGA, and his former Fool subscriber service, Global Gains, still recommends CGA. It also recommends YONG.

    I own both CGA and YONG, so I'm not trying to show that one is bad and the other good. I'm just tired of shoddy, inaccurate fluff pieces by people who don't even work for Motley Fool. Get someone with a clue to fact check these things or don't publish them.

  • Report this Comment On January 24, 2012, at 11:12 AM, JohnMaxfield37 wrote:

    kidchicago2 -

    For an investor with your interests and opinions, you'd be better served by our subscription services where all the content is produced by in-house analysts as opposed to independent contractors. The one best suited for you, considering your Chinese holdings, would be Global Gains.

    - John

  • Report this Comment On January 24, 2012, at 11:36 AM, kidchicago2 wrote:

    John, I subscribe to Global Gains, as well as Special Ops. That's how I know that CGA and YONG are both active recommendations of Global Gains, and that the implication in this article--that YONG is a better stock pick because Fool analysts like it--is totally wrong.

    You can't disclaim any obligation to publish accurate information simply by saying you give it away for free. This was published on the Fool's site by a contractor paid by the Fool to write it. Presumably, some paid Fool employee edited and approved it. The Fool thus has some responsibility to make sure the article is factually correct and logically cohesive. As with so many of these independent contractor pieces, this one is neither.

  • Report this Comment On January 24, 2012, at 1:36 PM, kidchicago2 wrote:

    John, let me add an important caveat to my earlier post: I think the heart of your article is useful and well written. It's only where you get to the "actionable advice" portion, where you bash CGA and praise YONG, that I think you go astray. Maybe someone else wrote that, I don't know. I don't see what it has to do with the rest of the article, so maybe it was an afterthought. But that's the only piece I have a real issue with.

  • Report this Comment On January 24, 2012, at 1:42 PM, JohnMaxfield37 wrote:

    kidchicago2 -

    I appreciate the caveat and defer to your judgment on CGA and YONG.

    - John

  • Report this Comment On January 24, 2012, at 1:53 PM, ETFsRule wrote:

    I believe chart 1 would be more meaningful if it used a log scale. Otherwise, because of exponential growth, it's hard to tell which years had the highest % growth in GDP.

  • Report this Comment On January 24, 2012, at 1:55 PM, ETFsRule wrote:

    Log scale would only be needed for the right-side axis.

  • Report this Comment On January 24, 2012, at 7:25 PM, CaptainWidget wrote:

    China is just waiting. Once their middle class is developed enough and broad enough to start buying the goods they are producing, they'll let the currency float and sell off their remaining dollar reserves.

    This is going to be a tough process for American consumers and producers, but it's necessary. The chinese are funding our crazy public and private debts so that we keep buying their junk. Once the chinese start selling their junk to each other rather than us and stop lending us money to buy their junk, we'll realize we aren't nearly as rich as we think. We're still the most productive nation on earth, but hopefully when China takes away the credit cards we'll appreciate the value of our productivity over the fun of our excess spending.

  • Report this Comment On January 25, 2012, at 7:25 AM, CSIHawaii wrote:

    kidchicago2 - 10

    John Maxfield - 0

  • Report this Comment On January 27, 2012, at 12:47 AM, FLOF wrote:

    Shouldn't the Americans be happy someone is giving them credit in their own currency while they continue to devalue it by printing lots of it? Obviously the Chinese don't want to devalue the USD, because that would mean loosing parts of what they lent to the US.

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