Comment 22: The impact of Chinese Yuan's revaluation (July 4, 2005)

Since the posting of Comment 15, titled "looming confrontation about the value of Chinese Yuan" at the end of January, the valuation problem of Chinese Yuan has suddenly become one of the hottest topics of financial and political circles. Several major developments have converged almost simultaneously. One is the declaration of Japan-America alliance to include Taiwan Straight in the scope of their mutual defense treaty, followed by China's anti-Japan mass movement. Within America the dormant Schumer-Graham bill, that will impose 27.5 % import tariffs on all Chinese made goods if China does not allow Yuan to revaluate upwardly by 27.5%, has received a strong support in U.S. Senate. U.S. Government has also discarded its ineffective low key prodding and has turned into often openly hostile manner to urge China to revaluate Yuan immediately. The connection among those events is discussed in Article 6 so will not be repeated here.

On June 30, just a few weeks before the scheduled vote of Schumer-Graham bill, the vote is postponed on the urge of the sponsors of the bill, Senators Schumer and Graham, after their closed-door meeting with Fed. Chairman Greenspan and U.S. Treasury Secretary Snow. The sponsors of the bill said that Fed. Chairman and Treasury Secretary have convinced them that China will revaluate Yuan within months so the bill will not be needed. Next day Treasury Department confirmed their conviction about Yuan revaluation.

There are also oppositions to the revaluation of Yuan beyond the circles obviously controlled or sympathized with the communist government of China; they are often western scholars and businesses that have invested in China. Sometimes they argue that even a sizable revaluation will not have any noticeable macroeconomic effect on America so why bother to pressure China, and sometimes they argue that a meaningful revaluation of Yuan will have severe consequences for America's economy, two apparently self-contradicting arguments. Some even try to say that a sizable Yuan revaluation will not have any effect on US-China trade balance, citing US-Japan trade as the example. The dramatic swings in US-Japan trade balances following meaningful revaluations of Yen have been discussed thoroughly in Article 1 and Article 2 posted on this website. Though we refer readers to those articles for details, we can confidentially say that Chinese Yuan is not an exception; a meaningful upward revaluation of Yuan will certainly shrink US trade deficit with China drastically. Subjecting to such crosscurrents, arguments and counter arguments readers probably are at loss about the real consequences of a sizable Yuan revaluation. In this comment we will assume that Yuan will appreciate against Dollar by 30% within a few years, and then analyze its effect on relevant economic entities. Only through such objective analysis we can understand the root cause of this problem, the current standing of the parties involved, and the probable future evolution of this problem that will have a significant effect on the whole globalization scheme.

China:

A sizable revaluation of Yuan will hurt Chinese economy and will cool its run-away boom. As discussed in Comment 8, Chinese economy is heavily dependent on exports, especially the exports to America. The explosion of exports is fueled by the influx of capital from Japan, Taiwan and America to build export oriented factories; the American capital that flows into China is actually money borrowed from Japan, Taiwan and other countries through America's exploding trade deficit. The capital inflow plus a trade surplus bring a large sum of dollars into the hands of Chinese and will naturally push up the value of Yuan. In order to keep Yuan pegged to Dollar to maintain its role as the proxy-exporter, Chinese Government buys up those dollars that flow into China. The buying of dollars means, of course, the selling of Yuan, or the issuance of a large amount of new Yuan by Chinese Government. Chinese Government is able to reabsorb only about 50% of those newly released Yuan through its monetary operations. The remaining newly issued Yuan thus flows into the hands of state controlled banks. Local Chinese governments borrow those newly issued Yuan from local branches of those state-owned banks and build power plants, steel mills, super size textile factories, infrastructures and even to engage in real estate speculations. Those fixed asset investments are the real root cause of exploding Chinese GDP growth.

Now consider a $10-product from China earmarked for export. Let us assume that $2 is the labor cost provided by China and the remaining $8 covers the import of raw materials and parts used in the process of manufacturing. With 30% upward revaluation of Yuan, the labor cost becomes $2.6, so the whole product will cost $10.6. This 6% rise of the cost will be a disaster for low margin products like low-level textile products. For higher-margin products this 6% rise in production cost can be absorbed so they are not affected very much. It should be noted that the aim of America is to reduce trade deficit with China. This means that Chinese exports to America must have a meaningful reduction since the export of America to China is not likely to increase by a significant amount as can influence the trade balance between two countries. Thus if this 30% revaluation of Yuan is not enough to achieve this reduction of Chinese exports to America, more pressure to push up the value of Yuan will follow, and eventually Chinese exports to America will wane. As the export opportunities from China diminish, the influx of foreign capital into China will slow down, too. Also as Yuan rises to a certain level, the influx of hot money into China will slow down or may even reverse the direction of the flow. All these factors imply that Chinese Government will intervene the currency market substantially less, and the issuance of new Yuan will be reduced. Therefore, Chinese economic growth will be curbed. The meaningful slow down of China's economic growth may cause a social problem and unrest, threatening the control of the government. That is probably the reason why the political leaders in China are so vehemently against the revaluation of Yuan.

Some may look at the experience of Japan and claim that Chinese exports can bounce back within a short time, like a few years, in spite of a meaningful revaluation of Yuan. However, the economic development models of Japan and China are very different, and the stages that two countries are in when a sizable currency movement occurs are also very different. We do not believe that Japanese experience applies here. Let us look into the Japanese experience more closely. Through 50's and 60's, the golden age of Japan's economic recovery from the War, Japan did not rely on trade surplus. Japan's trade was balanced in average during that period. Japan never relied on external capital or on external know-how to climb up the economic ladder. It is near the end of 70's, the internally grown Japanese industrial might has reached a threshold. Accompanied by the earnest globalization in early 80's, the floodgate of Japanese exports to America has been opened. This onslaught of Japanese exports has forced America to call for a Yen revaluation at the Plaza accord in 1985. The gesture of joint intervention was enough to push the already severely overvalued Dollar over the cliff, and Yen rose from 210 Yen/Dollar to 130 Yen/Dollar in the hands of a free currency market in a short period. This drastic revaluation of Yen, with a usual time delay factor of 2 to 3 years, curbed both Japanese trade surplus and American trade deficit. By 1992 American trade deficit had shrunk about 70%. However, Japanese industries continued to push for the self-reliant productivity improvement. By 1993 Japanese products have an edge over American counter parts again in spite of substantially revaluated Yen. Thus Japanese trade surplus and American trade deficit grew anew. It is the free currency market, trying to correct that menace of global imbalance, pushed Yen up to 80 Yen/Dollar and the effect of reducing the trade imbalance was starting to show up by early 1995. Then Japanese Government started its now infamous strategy of the great currency manipulation to hold Yen weak against Dollar and has sustained Japan's large trade surplus ever since. The situation of China today is very different. As mentioned before, Chinese economic development is heavily dependent on the outside capital and foreign know-how the combination of that can literally transform a poor backward entity into an economic powerhouse overnight. As the influx of foreign riches wither, so will the Chinese economy. Certainly China can switch to the mode of self-reliant development, but as experienced by every developed country, the road of self-reliant development is long and arduous; it will be in the scale of decades, not in years, even China succeeds in this new mode of development. At the eve of China's self-reliant development, China probably does not want to repeat the folly of Japan. For a self-reliant economic entity, not as a proxy-exporter as China now is, to run large trade surplus is like giving away its own blood for others to consume. In early 80's Japanese economy was in such a robust stage, the effect of the giving away of a large amount of blood in the form of large trade surplus was not keenly felt. However, in 90's when Japanese economy matures, the insistence of Japan's policy makers to run a mercantilist-like trade surplus has drained the lifeblood from Japanese economy, and has assigned Japan to a perpetual stagnation and deflation. In any event, a sizable Yuan revaluation means that the Chinese gold-rush era for outside merchants is definitely over, and China needs to search for its own growth, not the quick rich based on the foreign capital and know-how that flood into China in a gold-rush mentality.

United States of America:

At the event of one or a series of revaluations of Chinese Yuan to cut China's exports to America by a meaningful amount, there will be the usual time-delay of two to three years from the time of the currency movement to the time that exports from China actually drop off. During that grace period factories specialized in low profit margin products will start to relocate to other developing countries. If this transition goes smoothly as expected, imports to America will not be disrupted, and there will be no significant economic impact. The problem will be in the section of dollar's exchange rates with other major currencies like Japanese Yen, Taiwan Dollar and South Korean Won that are heavily manipulated by their governments. If those currencies rise with Yuan, America's trade deficit will shrink in time and an economic recession will rein. However, America must face this currency problem sooner or later. Currently Dollar is supported by the rising short-term interest rates as been pointed out in Comment 17 and Comment 21. When the short-term interest rates rise to the ceiling, then America must ask other governments to come in to continue the great currency manipulation to keep dollar overvalued, otherwise will see dollar collapse, trade deficit shrink and American consumers have less to consume.

Japan, Taiwan and South Korea

Low profit margin and labor intensive industries that are pushed out of China in the event of meaningful Yuan revaluation certainly will not return to Japan, Taiwan and South Korea. However, the movement of Yuan will deter high tech industries in those countries to move their production lines to China under the "jump on the bandwagon" type psychology. Their exports of parts to China will drop, but the drop can be compensated by the exports to other developing countries where the low margin and labor-intensive industries migrate. The more crucial question for those countries and for the whole world is what to do about their great currency manipulation. The significant revaluation of Yuan will push this crucial question to the forefront earlier. If they continue to manipulate their currencies after the means to support dollar through higher short-term interest rates are exhausted, then they will continue to export their own consumption power to America through their sustained large trade surpluses, and will assign themselves to the continued stagnation and deflation.

Hong Kong

As Chinese economic growth cools down due to a meaningful Yuan revaluation, Hong Kong will suffer mightily. Hong Kong dollar will also be forced to revaluate, and "Hong Kong merchants" who speculate on the real estates in China will suffer a devastating blow. The status of Hong Kong as the base camp for investments in China will decline, and Hong Kong's own real estate market will experience a period of stagnation and decline, too.

World commodity prices

As a significant number of export-oriented industries migrate out of China, and as Chinese economic growth cools down, Chinese demand of raw materials will decline, too. The developing countries that receive those migrating industries are diverse and are less likely to engage in massive fixed asset investments as China is doing now. Thus the aggregate demand for raw materials from those developing countries will not fully compensate the drop of demand of China due to the Yuan revaluation. We can expect the moderation of raw material prices. Especially the price of oil will level off and may even experience a period of softness.

Summary

A meaningful revaluation of Chinese Yuan will be a watershed event for the global economy. It will realign the global economic scene. It will also hasten the time table for the engineers of the current globalization scheme to face up with their own offspring, the monster of global trade imbalance, that, if not addressed promptly, will surely crush the global economy and usher in an economic depression of global scale.