Chill Out About China's Currency

April 15 will be an important day for U.S.-China relations -- it's the day the Department of the Treasury is slated to decide whether China is a "currency manipulator."

Normally a topic reserved for economics geeks and government bureaucrats, this somewhat arcane issue is now mainstream news. Paul Krugman's conducted an ongoing jeremiad in The New York Times, and populist pressure sparked a letter from 130 members of Congress to the Obama administration, demanding that China be branded a manipulator.

Firebrands aside, what is the issue here? Why is it important? And why do I risk vitriolic emails by thinking we should cut China some slack? Buckle up. Here we go…

First, some background
China has long fixed the value of its currency, the RMB, relative to other currencies. From 1994 to 2005, the government held the value of the RMB to the dollar steady, at a little more than 8 to 1. Facing pressure from other countries who believe that China's artificially weak currency makes its exports too cheap, China revised its currency policy in 2005, pegging the value of the RMB against a basket of world currencies. This caused the RMB to strengthen gradually against the dollar over the past five years, and it now takes 6.8 or so RMB to buy a dollar. (Many critics, including the International Monetary Fund, believe that remains too low.)

Why would a country want a weak currency? In China's case, manufacturing for export is and has long been a huge part of its economic growth engine, and a major employer of working-class Chinese. In fact, China's incredible GDP growth over the past 25 years, and the development of megacities such as Shenzhen in southeastern China, has largely been built on export manufacturing. China has enjoyed a global trade surplus that checked in at almost $300 billion in 2008, and almost $200 billion during a depressed 2009. This growth in the manufacturing sector has created jobs and helped China cope with an urban migration that now numbers in the hundreds of millions.

Without the jobs that export manufacturing creates, China would likely have hundreds of millions of people unemployed and wandering around in cities -- a recipe for social unrest. I believe the Chinese government has made avoiding that situation its No. 1 priority. (They refer to it as creating a "harmonious society.") Thus, the country is more than willing to keep a weak currency in order to preserve jobs.

Gaps in the armor
It's becoming increasingly clear to China and others that such a policy is not sustainable. Not only is it bad for international relations, it's bad for China's long-term economic development. This became obvious in 2009 during the global economic downturn. Demand for Chinese exports dried up, prompting layoffs in China regardless of the value of the currency. Worse yet, the country had very little to fall back on to spur growth in other sectors of the economy. This is why China's $585 billion stimulus plan was so focused on infrastructure development, including significant spending on highways and high-speed rail.

Capital spending, however, is also unsustainable (a country can only build so many roads). In order to diversify the economy, China is funneling more and more money back into job-creation initiatives in rural China and sectors such as health care -- domestic industries that would ostensibly benefit from a stronger RMB.

Why the controversy?
If the consensus is that China should have a stronger currency, why the vitriol? The debate centers on timing. China would like its currency to gradually revalue, minimizing the chances for unemployment in the manufacturing sector -- and therefore, the odds of social unrest. But countries now seeing high unemployment, such as the U.S., would like it to happen now, so that they can reinvigorate their own manufacturing sectors and put unhappy unemployed citizens back to work.

Further, there's a rhetoric game that all politicians must play. In China, Communist Party leaders don't like to appear bullied by the rest of the world. In the U.S. and elsewhere, election-minded leaders get an easy talking point if they can blame their constituents' woes on someone else. As commentator Michael Pettis wrote recently (and the whole column is recommended reading on this topic), "[I]t is also always easy to get votes by bashing foreigners -- this is one of the many attitudes that the U.S. and China share."

What happens next
Yet China doesn't need to revalue its currency in order for the U.S. to make its products more competitive. Krugman, for example, has proposed a 25% tariff on Chinese imports.

Alas, that approach would set off a significant trade and diplomatic row between the U.S. and China, without necessarily having any measurably positive near-term effect on the unemployment picture here in the U.S. Sure, it's a principled stand, and not without its idealistic merits. But whether or not one thinks the U.S. could withstand China's selling Treasuries and/or cutting itself off diplomatically from us, the long-term cost would be very high.

Instability in China would be bad news, as would any attempt to hurt our ties to a country that is moving in the right direction, and that will be a major world power for the foreseeable future. Finally, I have some compassion for Chinese workers, who might be massively displaced by a manufacturing sector that generally isn't prepared to compete with the world on anything other than cost (though I recognize those jobs would be picked up by folks in other very poor places, such as Vietnam).

The takeaways for investors and policymakers
China's economy needs to diversify, and the country is moving in the right direction. As a result, I believe China is entitled to more time as it goes about this important work. That said, U.S. policymakers and international bodies should keep close tabs to make sure China is, in fact, letting a gradual process of revaluation proceed, rather than continuing to fall back on the easy, artificial money of export manufacturing. While a revaluation does not need to happen today, it does need to happen. Politicians with electoral agendas simply shouldn't try to accelerate that process to an unwieldy pace, especially given the significant potential consequences.

For investors, China's inevitable revaluation means that Chinese stocks are a good place for your money. These stocks will appreciate in value as the RMB strengthens against the dollar over time. At Motley Fool Global Gains, we prefer companies with a domestic -- and even better, rural ­-- focus, such as China Green Agriculture (NYSE: CGA  ) , Yongye International (Nasdaq: YONG  ) , and China Mobile (NYSE: CHL  ) .

On the flip side, we're generally avoiding Chinese exporters and outsourcers, because they are benefiting today from a fleeting comparative advantage, given the country's artificially undervalued currency. These companies include Nam Tai Electronics (NYSE: NTE  ) , Wuxi Pharmatech (NYSE: WX  ) , and Mindray Medical (NYSE: MR  ) .

The issue with China's currency is not going away, given both sides' unwillingness to compromise. What happens on April 15, however, will have a significant effect on U.S.-Chinese relations, and will no doubt heighten the rhetoric. In thinking about the issue, try to maintain a global, rather than a country-centric view. In fact, that's good advice no matter what international issue you're considering in these changing times.

Tim Hansonis co-advisor of Motley Fool Global Gains. His Global View column appears every Thursday. He owns shares of Yongye International. Mindray Medical International is a Motley Fool Rule Breakers selection. China Green Agriculture and Nam Tai Electronics are Motley Fool Global Gains picks. The Fool owns shares of China Green Agriculture and China Mobile. The Fool has this global disclosure policy.


Read/Post Comments (14) | Recommend This Article (24)

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  • Report this Comment On April 01, 2010, at 8:47 PM, mtghack wrote:

    How is MR an exporter or outsourcer? They sell mainly to mainland hospitals. They export for an added kick to revenues but that is not their primary business.

  • Report this Comment On April 02, 2010, at 2:18 AM, normgarnett wrote:

    Isn't it the same, if the USA devalues its currency as if China re-values.

    They are two of the biggest, if not the biggest, exporters. So why not.... surely that is what the USA wants, isn't it?

  • Report this Comment On April 02, 2010, at 5:13 PM, ChrisBern wrote:

    Don't forget that we are all buying Chinese goods cheaper based on their weak currency and our relatively strong dollar. Krugman wants to increase the price that American consumers pay for those goods by 25%. No thanks, Paul. I prefer the 25% discount!

  • Report this Comment On April 02, 2010, at 6:43 PM, Aristocrisis wrote:

    Read this study (by a research panel) that found there was only one artificial undervalued currency - the japanese yen. The list of artificially strong currencies, on the other hand, was long; amongst them UK. This study was conducted some years ago, maybe it would look different today.

    You could also flip the coin and say the US dollar is kept artificially low by a seriously dangerous fiscal policy. Every country wants to help its exporters; although in very different ways.

  • Report this Comment On April 02, 2010, at 6:45 PM, Aristocrisis wrote:

    Read this study (by a research panel) that found there was only one artificial undervalued currency - the japanese yen. The list of artificially strong currencies, on the other hand, was long; amongst them UK. This study was conducted some years ago, maybe it would look different today.

    You could also flip the coin and say the US dollar is kept artificially low by a seriously dangerous fiscal policy. Every country wants to help its exporters; although in very different ways.

  • Report this Comment On April 02, 2010, at 7:59 PM, Racovius wrote:

    Wow, your hitting the big time! Since this is mainstream news, and since in the next few days people will SURELY Google this: type "artificially weak currencies" in the search query. You'll get Tim Hanson's article! Now sit back and watch Google searches for "artificially weak currencies" reach into the millions!

  • Report this Comment On April 02, 2010, at 8:01 PM, Racovius wrote:

    Aristocrisis, can you point me in the right direction for your study? I'm interested in looking at it, and maybe they might have something up to date.

  • Report this Comment On April 03, 2010, at 2:58 PM, TMFMmbop wrote:

    News today is that the US is delaying the report on China's currency: http://bit.ly/auHSBQ

    Tim

  • Report this Comment On April 04, 2010, at 7:40 AM, globalsailor wrote:

    Quite a good article. I never thought that avoiding social unrest was the reason for the fixed currency.

  • Report this Comment On April 04, 2010, at 9:51 PM, Dude119 wrote:

    I don't understand how Tim Hanson can say that China is moving in the right direction, when they are increasingly becoming hostile to foreign firms both within and outside china. Just a few examples:

    They recently held a kangaroo court for 4 rio Tinto employees and found them guilty of "crimes against the state" and didn't allow the media to attend, started a "Buy China" campaign last year that effectively forces Chinese companies to buy only other Chinese goods, has been caught stealing information from Foreign companies (Google, Yahoo), has seen the US Chamber of Commerce, usually a strong Pro Chinese business ally, call the current investment and business climate for American companies in China as increasingly difficult.

    China has been manipulating their currency for years - when they joined the WTO in 2001, they agreed to be held to the same standards as the rest of the world. They are clearly violating WTO laws and they should be held accountable.

    The Chinese government has dangled the prospect of 1 Billion+ possible consumers for foreign products for years , and the results are becoming clearer - China will delay and protract for as long as they can take advantage of a situation (in this case currency) while telling us that any move on our part would jeopardize market access to those Billions of Chinese consumers.

    Well, that game is getting old - its obvious China is laughing all the way to the bank.

    We've been taken to the cleaners by them and its time they join the big boys on the world stage and play by the WTO's rules. We'll see if they'll be a superpower after that...

  • Report this Comment On April 05, 2010, at 1:25 AM, LatifK wrote:

    Dude119 hits the nail right on in terms of his assessment on both the lack of access to the Chinese markets for foreign co's and its pretty well documented policy of corporate espionage.

    To further add to Krugman's suggestion of a 25% tariff tax, why don't we ALSO require any Chinese company wishing to do business in the US be 51% majority owned by a US citizen.

    Whats good for the goose has got to be great for the gander in this case.

    But alas the Chinese have long been playing chess while the US was playing checkers. Without them to buy our debt, we would probably go into default at this point or having our T bonds rated along side Greece and Spain's.

    For that and many other reasons, the most the US can do while getting slapped is say "yes sir, thank you sir, may I have another"

    Cheers-

  • Report this Comment On April 05, 2010, at 5:17 AM, Aristocrisis wrote:

    @Racovius:

    Found the article I mentioned. It's here:

    http://www.economist.com/business-finance/economics-focus/di...

    It's an interesting take on how to measure different currencies strength. (Morgan Stanley-based). I think it requires subscription to Economist, but try it.

    Have A Nice Day!

  • Report this Comment On April 05, 2010, at 3:29 PM, jdlech wrote:

    Cheap prices are great until it's your job that is lost to China. That's the sticking point - those who still have a job seem to think theirs is not the next one to disappear.

    What we need to do is rebuild Americas manufacturing and, while it comes on-line, impose tariffs on foreign goods. The extra costs to consumers are more than offset by the extra tax revenue. Remember the federal level is not so much interested in the individual as it is in the nation as a whole.

    Thus, protectionism Vs. China

    ► reduces unemployment - reducing the amount of money spent on unemployment insurance.

    ► increases federal and state tax revenue

    ► reduces the trade deficit and

    ► improves GDP and the economy.

    But it also increases inflationary pressure a small bit. The main point is to rebuild American manufacturing BEFORE imposing tariffs. There's no point if it will not create or protect an American job.

    One final point; we are NOT here to aid the Chinese economy or the Chinese worker. We are here to help ourselves. If you want America to put Americans first, the course of action is obvious. We've tried the 'free trade' rout and it cost us jobs, economic power, GDP, and tax revenue; far more than we originally expected. It's time we reversed course and reverse our mistake.

  • Report this Comment On April 06, 2010, at 1:57 PM, TMFMmbop wrote:

    The manufacturing jobs China has today aren't coming back to America. They'd go sooner to somewhere like Cambodia or Vietnam. These are generally not skilled labor jobs, but commodity jobs that come with low wages and no benefits.

    Germany, however, can compete in manufacturing because its makes precision items. It's competing on quality, not price. If we want to bring manufacturing back to this economy, that's the model to follow.

    Also, free trade has not cost us GDP. Our economy is bigger because of free trade, it's just that the jobs that are lost and the jobs that are gained happen to be in different sectors so the pains/gains are felt in different places.

    Tim

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