Thursday, October 6, 2011

How the USA can beat China in the Trade War. How can we make Yuan stronger compared to USD.

So far, this blog is used to archive my favorite articles- articles written by others. (Lately though, I have started using Facebook to store links to articles I like). I am in a mood to write something today- my own thoughts. So tighten your seat-belt and get ready to take a ride with my wild thoughts.

There is an increasing demand within US to force China to let its currency float freely. Everyone knows (or should I say believe) that China is keeping its currency artificially weak so the products made in China have significant competitive advantage in international markets.  Now US is frustrated with slow economy and continuing higher unemployment at home. There is nothing much that can be done. Fed, Senate/Congress and President are trying. We tried monetary policy, Fiscal policy but looks like these tools have lost their edge. This economic animal no longer responds to these stimulus/injections. Jobs can not be harvested in a farm or made on an assembly line! Every job out there has to provide more value to its employer. A 60k per annum job has to provide at least 60k of value.  Now when a job/work is portable and can get done overseas for 10-20k, why would one pay 60k within the USA? I wouldn't. Probably you wouldn't either. In hiring a worker in the USA, a company has to pay 10-20k per annum in health benefits and other benefits. In such scenario, unless US employees become competitive, on the wages I mean, there is not much hope to get more jobs created. We kept saying about high productivity of US employees. That is also due to higher automation and subsequent efficiency gains which on the other hand causes job losses. (This can be a new article itself about why jobs are not springing up in the USA so I am going to stop talking about it here.)
Every businessman knows that US employees are expensive. Providing health benefits to employees is expensive. For the money that is spent by employers in highly inflated US Healthcare, and other benefits, a full job can be paid in many other countries. Why not we try to bring down Healthcare expenses? Healthcare costs is a signficant factor behind expensiveness of US employees!
Every politician knows, I guess, that creating jobs within US is a difficult job itself. So now starting a trade war against China can act as a morphine for 300 million Americans. Now we can divert public's attention and tell people that it is China that needs to be blamed for the problems in the world's most powerful nation. For lack of jobs at home, it is that dragon nation that needs to be cursed for subsiding its manufacturers by keeping its currency low. The politicions of the US are not at fauth for this problem at home; it is the China and it is its currency policy.
This tactical and vocal war between these nations is going to get worse and worse. If this intensifies, I can see the post-war picture. It is ugly. No one gains. Let us focus on the main topic here though. US needs someone to blame for the problems at home. And now we have found one. The way former President George Bush brain-washed Americans to get into a war with Irad, this is a relatively easily sellable idea to get into a trade-war with China.
When I think about this from China perspective, frankly, I don't know what is going on in their heads. But here is what I believe is going on. Let us first understand the current situation. China exports much more than it imports. So for businesses within the country, they have more dollars (Euros, Pounds etc but we will refer to USD for simplicity) coming in (as payment for exports) and the dollars going out for payment for imports. As per text books, this is a scenario of excess dollars with Chinese companies. In a market economy, this lower demand (or higher supply) of dollars should actually cause the value of dollar to drop.  Now in reality, the Chinese government plays in the currency market and absorbs all excess dollars!  They buy dollars and sell Yuans. This prevents Yuan from appreciating (and dollar from depreciating). Over last many years, this constant buying of US dollars has resulted in Chinese government having accumulated 2.3 trillion dollars worth of foreign reserves!!!
What started as a way to encourage local exporters has become an issue now. This enormous forex reserve is stuck in the throat of China. It can not be swallowed or vomited out. Let me explain what I mean by this.

These foreign exchange reserves are mostly in US dollars and some in Euro, Yen etc. Not only US, now Euro and Japan aren't doing that great either. Interest rates in all these countries are also almost close to zero. So this giant portfolio of 2.3 trillion dollars in earning peanuts for China. I think the return on this portfolio is around .3% of so. On the other hand, Chinese government must have borrowed trillions of Yuans to finance these forex reserves (unless the government is running budget surplus every year and has built up reserves, or just prints currency to pay for dollars). Interest rates within China are much higher compared to rates in USA and Japan. So on this 2.3 trillion forex portfolio, if government is losing say 3% in interest rate differential (what it earns on forex reserves vs what it has to pay on government borrowings in Yuan), the annual losses are around 60 billion dollars. Take into the account the current appreciation in Yuan which is around 5%  vs dollars. In other words, the dollar is weakening by 5% per annum. (US Politicians want China to make Yuan stronger by 20-30%). This 5% depreciation in dollar value causes the 2.3 trillion portfolio to lose value of around 100 billion dollars compared to Yuan value. So to keep the Yuan weaker, China is losing (or spending) around 160 billion dollars a year!!! No one would like this kind of losses! I am sure the treasury department of China must be hating this too.
One's loss is usually some one's gain. China's loss here is probably US's gain. I am refering to just the financial side. China loses money on its forex reserves. This helps US borrow cheaply from China. This is one major reason why interest rates are low in the country right now. Bond pundits are forecasting for the last 5 years or so that interest rates would rise in the USA. On the contrary, they are falling. Now the Portfolio Manager on the US side, the Fed chairman, loves this like a kid with a sugar pot. He can keep interest rates lower in the name of helping millions of American. As a borrower with China, he knows that he is going to repay the debt with cheaper dollars in future! So this is a win situation for the US: we have a lender that lends money almost interest free and the lender will be paid back with cheaper dollars. This is a gain on current account as well as capital account.
On the other hand, China is stuck in my opinion. There is no strong investible currency in the world. Canada and Australia are strong but they are not big enough to digest investment of 2 trillion dollars!!! Euro was coming up as an alternative to USD but now they have more issues with crisis in Spain, Greece etc! Japan is plagued with low rates for last two decades. IMO China is stuck with USD. US is stuck with low growth and high unemployment. So the US interest rates may stay lower for long time. US may be loving this interest free (almost) lending by China. US may also be loving this slow depreciation of USD!

Now if USA succeeds in getting China strengthen its currency by say 20%, the Chinese forex portfolio of dollars will lose that much value! Almost 500 billion dollars will change pockets- from Chinese government to US government in terms of value/purchasing power. It is not easy for China to sacrifice $300-400 billions in value of forex reserves. More importantly, the strengthening of Yuan will bring a slump in China's manufacturing sector. If their exports drop, yes, they will, if Yuan gets stronger, that can create a slow-down or recession in China. I don't believe China is ready to take any sudden move here where they will lose on thier Forex portfolio and willl cause economy to slow. Also, for China, the other alternative is to do nothing with regard to Yuan value and this will cause them to lose $150 billions a year. This is the annual cost for keeping Yuan weaker and dollar stronger. (If you were the Chinese premier, what would you choose?)

What alternatives are out there? Here are some crazy ideas.

1) US government can start playing the currency market too. They should start buying Yuan (Yuan is a really good investment! You buy Yuan and then lend this money in China. You will get around 5% return and your Yuan is expected to keep getting stronger. This is one of the best investments out there IMO). Now US government is almost bankrupt. Congress is not willing to raise the debt limit. So unless US starts printing dollars to pay for the Yuan, this is not a feasible alternative.

2) ....I am thinking...Do you have any idea? Please post it here.
(Got to go now. Will continue later)


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