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
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
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 Hanson is 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.
