by Thomas P. Au, CFA, Author & Market Analyst. September 15, 2006
Once again, President Bush's Administration has been leaning hard on China to re-value its undervalued currency, the yuan. The Chinese nod politely and make some modest adjustments, but basically, the exchange rate between these two currencies will stay put for as long as Chinese, not American, monetary authorities can maintain it.
Raising the Yuan Would Make China's the World's Second Largest Economy
It would make sense to allow the yuan to rise to give a truer picture of China's economy. Even I was surprised to read the other day that China's GDP using purchasing power parity (rather than foreign exchange because the yuan is way undervalued), is about $9 trillion, versus $12 trillion for the U.S., and just over $2 trillion using the official exchange rates. On a purchasing power parity basis, the yuan should be less than 2 to the U.S. dollar, rather than almost 8. But this would have the drawback of overstating the relative size of the Chinese economy because it ignores "non-tradable" goods and services like health and beauty care, which are more prevalent in the United States than in China and therefore contribute far more to the economy stateside. My best guess is that a more reasonable level for the yuan would be about 4 to the dollar, meaning that China's economy is perhaps twice as large as the official figures indicate. This would make China the world's second (instead of fourth, officially) largest economy, just ahead of Japan, and well ahead of Germany.
Either way, "marking to market" the yuan would provide a windfall to China's GDP, although this would hurt the country's balance sheet by devaluing its foreign exchange reserves. But better now than later (in fact, reserves have grown exponentially in the past two or three years, so the hit would have been much less if the revaluation had taken place earlier in the decade). On balance, the Chinese economy would be a large gainer after netting out the two effects.
But It Would Hurt the Job Market
So why is China not pursuing such policies? The short answer is "jobs." The country has 1.2 billion (or more) people, many of whom are peasants seeking to improve their lives by moving to the cities because of the inherent poverty of the rural areas. Keeping a "critical mass" of them happy is necessary for social and political stability. In order to effect this, it is necessary to have a large pool of low-paying (by world standards) urban opportunities, many of which amount to "make work" positions that are still more remunerative than farmwork. An artificially weak currency is an important ingredient of such a strategy.
Smoke and Mirrors
In fact, China is probably less concerned about the actual size of its GDP than it growth rate. Marking up the yuan would lead to a one-time increase in current GDP, but make Chinese goods less competitive on world markets, thus reducing absolute GDP growth in the future (while raising the base against which percentage comparisons are made). This, in turn, would lock in the already large wealth gaps between the "haves" and "have nots," because most of the resulting windfall would go immediately to the former, while leaving less to go around in the future. Thus, a larger economy today means less potential for a satisfactory adjustment tomorrow. On the other hand, as long as growth rates remain turbo-charged, even off a low base, the masses can hope for a rapid improvement in their living standards, poor as they are today. I have hinted in the past at my belief that this improvement is largely a matter of smoke and mirrors, but creating illusions is one way of keeping the peace.
A Rock and Hard Place
What threatens this arrangement is a high price of oil, and other commodities, which are still invoiced in U.S. dollars. That is the one thing that would induce a major change in the exchange rate. Expensive oil would clearly hurt the Chinese economy, although bringing its (yuan) price down through a revaluation would provide some relief. But this just catches the country between a rock and a hard place. What's worse, a continuation of high oil prices would drive a wedge into U.S.-China trade by reducing the purchasing power of the American consumer, thereby turning the so-far virtuous cycle of U.S. consumer (over) spending-Chinese capital (over) spending into a vicious cycle.
Only God Can Do This Job
So who's right about the exchange rate? On pure economics, the Bush Administration. But we have to live in the real world, and the Chinese authorities probably have a better grasp of the political realities of their own situation than the Americans. Given the potential for unanticipated consequences, wishing for a stronger Chinese yuan could be a case of "Be careful what you ask for." And it's possible that neither the Chinese nor the Americans have a good answer to the world's most intractable economic problem; the American trade deficit with China. All this reinforces my fear that the world's economy has grown too complex to be navigated without major pain by mortal men. (I used to say, "God can do this job but not Alan Greenspan.")
© 2006 Thomas P. Au
Thomas P. Au, CFA | Author & Market Analyst, R. W. Wentworth | New York City, NY | Email