Comment 15:Looming Confrontation about the Value of Chinese Yuan (Jan. 31, 2005)

A bill is pending in US Senate to impose 20 plus percentage of import taxes on all Chinese imports unless Chinese Yuan is upwardly revaluated by a similar amount. This bill is sponsored jointly by Democratic and Republican Senators and was introduced about a year ago. The consideration of the bill has been suspended to give US Government time to persuade Chinese Government about the revaluation of Yuan. However, after one year of fruitless attempt by US Government to talk up Yuan, this bill seems to regain the focus and has a good chance to be enacted into the law in 2005, especially under the changed environments among US and international economic policy makers. The school of economists who have pushed for free trade at any cost is forced to argue that the loss of US jobs to developing worlds like China is good for US economy, and is ridiculed in front of the public opinion. Even the Federal R eserve Chairman, Alan Greenspan, has changed his tone. He was reiterating that the large US trade deficit will be taken care of painlessly by "free markets". Now he is issuing a warning about the unsustainability of this enormous US trade deficit and wants currencies to float freely without government intervention to rebalance this imbalance in the globalization scheme. This, of course, means that Chinese Yuan must move up sharply, and US Government apparently shares this view. Only a handful of large Chinese good importers want to keep Chinese Yuan weak so that they can continue to reap huge profits through the import of inexpensive Chinese made goods. In the international front, Japanese Government is most eager to see the upward revaluation of Chinese Yuan, and Europe is not far behind. If Chinese Yuan continues to be pegged to US Dollar, and if US Dollar falls sharply against Japanese Yen, then Chinese Yuan will also experience a sharp devaluation against Japanese Yen and within a short period a large number of Japanese manufacturing jobs will flow to China. To prevent this kind of disaster to happen, Japanese Government will have no choice but to continue to manipulate the currency market with whatever amount of money necessary to support the value of Dollar. The amount required for such manipulation will escalate steadily; from near 400 billion dollar buying last time to one trillion dollar buying soon, then to two trillion dollar buying and so on with no end in sight. Under such consideration, we believe that the above mentioned bill will not encounter any strong resistance domestically nor internationally, and will probably be passed or Chinese Government gives in and revaluate Yuan by a satisfactory amount.

Let us analyze the effect of this 20 plus percentage import tax against Chinese made goods. The reason that multinational manufacturers shift their production lines to China is to take advantage of inexpensive labor cost and the lax environmental and regulatory controls over there. The raw materials and the components for those goods for the reexport to USA are mostly imported into China. The raw materials are, of course, imported from various resource-producing contries, and the components are imported from Japan, Taiwan, South Korea and other places. The added value by China to those Chinese made goods is usually only a fraction of the final price that the goods command when they pass US customs. This 20 plus percentage import tax under proposal will not only tax the portion that China contribues, but will also tax all the raw material and components went into those goods but not contributed by China. Thus this proposed import tax will cause a very sever blow to Chinese made goods, and China will see a sharp curtailment of its exports. Low profit margin goods like textiles probably will be wiped out over night, and those jumped on the China band wagon to expand their textile investments in China will see heavy financial losses. The high margin electronic goods probably will withstand the shock better than the low profit margin goods. As China's export industry is hurt, the capital inflow to China will slow down. Since Chinese economic growth is so dependent on exports to USA and the capital inflow, Chinese economy will experience a major slump if that import tax is enacted. How will this import tax impact US economy? We should note that the indispensable part of the globalization scheme is Japan, and to a lesser part Taiwan and Europe; they are the source of global capitals in the form of their chronicle trade surpluses without the matching capital inflow. Without those capitals US consumers can not borrow and spend, and the whole globalization scheme will just collapse. China is not an indispensable link in this globalization scheme. If goods made in China become not cost effective, the manufacturers will simply move their production facilities to other developing countries like India, Indonesia, Vietnam and so on. Some production of high tech goods will probably return to places like Taiwan, Hong Kong, Singapore, South Korea and even some back to Japan. If we look into the price of a Chinese made garment sold in US department stores, say a dress costing $50, the cost when this garment passes US custom is probably like $5 or below. The 20 plus percentage import tax will only increase the over all price of this garment by about $1.25 out of the price of $50, that is, to increase the price by 2.5%. Thus this 20 plus percentage import tax will not drive up US inflation in any significant way and the intermediate term impact on US economy is minor and temporary.

The long term effect of this import tax on the global financial market is more difficult to analyze. First we must project how Chinese Yuan will move after the imposition of the import tax. If Chinese Government insists on the currency peg, and foreign capital stops to flow into China, it may need to buy back Yuan by relinquishing a portion of its vast dollar reserve to prevent the fall of Yuan. This kind of action will prolong the negative effect of the import tax on Chinese economy. If Chinese Government lets Yuan float without intervention, Yuan will fall against Dollar and the negative effect of the import tax will be nullified graduately until China becomes competitive again as a manufacturing base even with the import tax. However, if Chinese Government tries to freeze the value of Yuan vs. Dollar at that lower level, then the whole history will repeat itself to no one's benefit. If Chinese Government stops to get involved in the currency market manipulation after Chinese competitive power is resumed, then it is the role of a free currency market to self regulate the trade balance, and future conflict between China and USA can be avoided. If Chinese Government tries to retaliate against the import tax by liquidating its dollar holding for Japanese Yen and Euro, the situation quickly becomes very complicated. This kind of action certainly will push Dollar sharply lower against Yen and Euro. If nothing is done, Chinese Yuan will also devaluate sharply against those currencies and China can shift its vast exports to Japan and Europe. In those places the mobility of labor is much worse than in USA. When massive imports from China hit, it will simply push the economies of Japan and Europe into a deep recession, and they will not hesitate to follow the foot step of USA to impose similar import tax against Chinese made goods. This means that China will be isolated from the globalization scheme, whereas US trade deficit will be curbed followed by an economic recession caused by the shrinking trade deficit, that is, US consumers will have less to borrow and thus less to consume. On the other hand if Japan and Europe decides to buy the dollar that Chinese Government releases in the phase of retaliation, whole thing will evolve slowly. US can continue to run huge trade deficits by importing from developing countries other than China, and Japan and Europe will continue to run large trade surpluses. What happens to China under that senario? If Chinese Government still wants to keep the peg, then Yuan will be suspended along with Dollar, and the recovery of Chinese economy and the shift of Chinese export to Japan and Europe will be slow. If Chinese Government retaliate, Japan and Europe come in to support Dollar from a sharp fall, and then Chinese Government let Yuan to float freely without further intervention, then Yuan will fall faster against Dollar than the case of no intervention by Japan and Europe on the behalf of Dollar. In any event once such an import tax is enacted and Chinese exports is curtailed, it will take a draconian effort to reassure multinational companies that China can be a viable export base to USA again. We should also note that if the 20 plus percentage import tax is insufficient to curb the exports from China, the rate of the tax can be arbitrary increased until it really bites and the above arguments become relevant.

What if Chinese Government act before the bill and let Yuan to float up, say by 20 plus percentage points? In that case the effect will be minor than the import tax since only the portion contributed by China in those exported goods will be effected. However, the problem of this approach is that the amount of revaluation of Yuan must be large enough to cause Chinese exports to USA stop growing; this, if happens, will also cause a slump in Chinese economy. If the amount of revaluation is not large enough and Chinese exports to USA does not level off, then the bill of concern will come back sooner or later.

In summary we believe that the show down about the valuation of Chinese Yuan is unavoidable and it will come sooner than many in the markets tend to believe.

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