Mellow Yellow: US Dollar vs. China Yuan
"China is a big country, inhabited by many Chinese." - Charles de Gaulle
As seems to happen every so often, "the 'bull' is in the China shop." Markets are again mellow on the dollar and turning yellow on China.
For obvious reasons the world is preoccupied with China. And, so it should be. As such, we have read numerous comments on China lately. Will its economy crash? Will China revalue its currency? There are at least four reasons why popular consensus on China may be as wrong as it was during the 1998 Asia crisis. Considering them, we don't see how one can be yellow on China while being mellow on the other. It betrays a misunderstanding of a new and unprecedented state of geo-political affairs.
It is critical to realize that one can't predict doom for China at this late great stage of world trade without worrying about the implications for the US and Europe. In this context, we challenge the recent popular views on the US dollar, the euro, energy and commodity price trends.
A Lot of Yarn
Surging apparel and textile exports from China this year are threatening to bring global trade relations to tatters. Cross-border yarning is all the fashion. But, this flare-up must be seen in the context of longer-term trends.
As we have mentioned in our strategy publications for some time, the axis of the world has pivoted radically over the past decade. Crucially, the unified West of the Cold War era no longer exists; neither is America any longer the penultimate financial/economic consideration for long-term investment policy. No doubt, America still holds sway currently. But, over the long-term, other key pivots are to be found in China ... even Europe of whatever future form.
With respect to China, a more prescient perspective than de Gaulle's (see above) is represented by this recent comment from Madeleine Albright, former US Secretary of State: "I think that at the least the United States underestimates the growing power of China. It is an immense country with energetic people which has great ambitions for itself." (May 11, 2005, Lisbon).
An epic shift has been in progress over the last two decades, yet it is only recently that some have come around to see current events as part of a longrunning agenda. China's intentions are not likely to be stopped by recent concerns about unfair competition, an inconvenient impact upon energy and commodity costs for the rest of the world ... etc. Perhaps delayed, yes, but not ultimately contained.
A similar perspective applies to the European Union. The recent "No" outcome for France provides another near-term flashpoint that needs to be seen in the context of longer-running process. Europhobes have been quick to cry doom, as they have countless times in the past. In this sense, the apocalyptic response to the French result is nothing short of predictable. However, viewed over a 50-year time-line, starting in the early 1950s, developments in Europe to date are still nothing short of unprecedented. Never before in history have so many people and countries decided to move towards unification in peace time. Did anybody ever think that 25 countries would never have some differences? America's own unification centuries ago was certainly more fractious than Europe's to date.
We are not apologists for the EU by any means. But, it is important not to lose context of long-term motivations, geo-political agendas, nor current day cross-country comparatives. Undoubtedly, Europe has its problems, but so does America, Japan and China. Whatever the progress to a final European Constitution, its economic and financial conditions seen in the aggregate are no more imbalanced than elsewhere ... in fact, much less so. In the meantime, America certainly shows no signs of a new direction. As such, the recent 7-month low of the euro should be seen as a buying opportunity.
A longer-term perspective is similarly helpful in deciphering China's present situation. Something big and unprecedented has been going on ... and has been for well over two decades, as mentioned. Yet the issues of the day - a surfeit of T-shirts in North American and European apparel markets, a managed currency, a wobbly Chinese banking system, a explosive accumulation of foreign reserves ... etc - are seen as detached from the long-term play.
Additionally, more important questions beckon: For one, will China's ascendancy continue over the longterm? Certainly, that is the objective. Dispelling any doubt on that point, Chinese President Hu Jintao recently again stated that it is planning to quadruple GDP to US$4 trillion by 2020.
But, another question beckons: Has China already become so influential in world commercial affairs, that her sneezes will now cause everyone else to catch a cold? Our answer - "most likely yes."
Critically, for some countries, a cold - in other words, a disruption of world trade and official fund flows - could risk being the economic equivalent of another Chinese export - SARS.
Lessons for a Traveling Mark Wai lo
Admittedly, in some respects we too are late-comers in recognizing the China phenomenon. It was only after the first economic miracle-country - the NIC (newly-industrializing country) of the 1950s, Japan - was in its first depression, that some essential realities about China finally dawned.
We remember the very day that the lights went on. On a research trip to Asia in 1992, we visited with the Chief Investment Officer of a major family fortune (with Mainland connections) in Hong Kong. This man, educated in Australia, was more than forthcoming about what was happening in China. Basically, his message was this: Western corporate executives were so greedy they were willing to supply all their technology free to China - and significant investment capital to boot - if they could have a crack at China's domestic market. He was chuckling as he said it. What's more, he didn't think foreigners were ever going to make much money in China. He was amused with the transparent gullibility of the "wai lo" (literally meaning, "foreign devils"). It was the Chinese version of a capitalist "monkey trap."
In retrospect, he was largely right. Few foreign investors - certainly not in stock markets - have made much money, although a sizable proportion of the foreign industrial entities (FIEs) are now profitable. Today, we continue to take that message to heart. It remains difficult for the average investor to gain access to investment opportunities in China. Yet, it also remains true that China stills holds the biggest influence over investment policy. We focus more upon China's external impact upon the world than we do looking for opportunities inside of China.
When Everybody Can See Clearly All the Way To China
1992 was rather late getting the "big picture." It was 1979 when Deng Xiaping first launched China's economic development program. The objective was to quadruple the size of China's economy over the next 20 years. China's leaders realized that globalization (which some more accurately saw as Anglobalization) was here to stay and that projecting worldwide influence and power was primarily a function of economic might ... at least so, for country of 1.2 billion in population. China met the goal set in 1979 and is already well-advanced in its goal to again quadruple the size of its economy by 2020.
And yet, it is only over the past 18 months or so that the world has again come to recognize the stupendous impact of a stirring China. Rising oil prices and a job-deficient economic recovery in the US have awakened a sleeping West. Now the implications of a booming China look all so obvious over the near-term. Oil prices are sure to hit $100 a barrel and more, and virtually every factory in the world will need to close down under the onslaught of Chinese and other Asian exports. These are among the views that are now held as near certainties. Maybe ultimately, but not anytime soon, we think. Not if China first sneezes.
Consider these four points that may cause current views about China to be wrong ... if not just mistimed.
1. China is not a Laphsa Dog
Will China revalue the Yuan? We admit that we don't really know. But, that doesn't stop us from thinking it through. Back in 1998, when virtually the world's entire investment community was sure that China would have to devalue (as did other countries during and after the Asia crisis) China stayed put. Imagine how more competitive China would have been today had it not done so! Six years later, most everyone is howling for China to revalue the Yuan.
It's important to realize that China is no one's Laphsa lap dog. Foreign pressure (gaiatsu) is not likely to be effective. China is not militarily dependent upon the West (as Japan was). This affords a measure of autonomy. Its deportment will be influenced by the fact that it has existed as a country millenniums before the US and other "high income" countries of today. Yes, China was left behind in the industrial revolution that took on steam in the West a few centuries ago. But let's also not forget that China was the world's largest economy for 18 of the last 20 centuries. China may choose an accommodation for the interim, but only if it suits its interests Let's face it: It'll do what it wants, when it wants, and most certainly not when it is being bullied.
When China finally chooses to act, it may be inconvenient for everyone else. At the very least, it would be wise to be prepared for just such an outcome.
2. The Feng Shui is Auspicious, But the Body Politic is Weak
Yes, everyone is griping about China's massive export surplus and its undervalued currency. We think it's mostly dragon breath without fire. Why? European officials have already admitted as much, lamenting that any counter actions stand to "hurt EU retailers." America, with its all-time high massive trade deficit, is less forthcoming. Just who is it in the US that really wants a higher Yuan - the "big money" behemoths, Wall Street and the MNCs, or the constituency with the largest block of votes, the formidable American consumer?
We think none of them. For one, the consumer has never directly connected the roulette wheel of a declining job market with cheap prices at Wal-Mart or Canadian Tire. The certainty of deals on Chinese goods is willingly chosen in return for the chance that someone else will lose their job. Our hunch is that it is too late to turn back the popular consensus. The North American shopper is addicted to cheap manufactured goods, and politicians know it.
As for Wall Street and many MNCs, they have actually been the major beneficiary of the booming "world's factory" in China. More than 500 multinational corporations have set up shop in China since 1990. It is these companies that account for almost one-half of China's exports. In the process, they have massively boosted profits by reducing their input costs (prominently, American labor). It is a fact that these MNCs are a very effective lobby group for China in Washington.
Most wonderful of all, the flood of cheap imports has helped Wall Street and the US administration by suppressing consumer price inflation and over-stating American productivity. The bottom line for America is this: China R' Us. Raise the Yuan only a little bit.
3. It's Bigger and Later Than One May Think
The China story is about more than just "a big country, inhabited by many Chinese." According to the latest statistics, China's GDP was 3.13 trillion Yuan during the first quarter of 2005. Just how big is that? On a straight currency exchange, that's equivalent to $1.5 trillion USD (annualized) or approximately 1/8 the size of the US economy. Since China has more than 4 times the population, that supposedly means that the average Chinese citizen has a standard of living only a fraction of the average American. Really? How is it then that this apparent nation of peasants has some $700 billion in foreign currency reserves (10x that of the US), is estimated to own a sizable portion of the US treasury bond market, and can afford a program of space flight? Because all these statistics depend on accepted accounting conventions.
Actually, China could already be the world's third largest economy when based on more realistic purchasing price equivalents. Some international groups (including the International Monetary Fund) think that the Yuan is undervalued by a factor of four. If so, the implications of this are significant. It implies that the size of China's economy is really $6 trillion, rather than $1.5 trillion. That in turn argues that China's integration with the rest of the world has only just begun. For one, it means that China could potentially attract much more capital as foreign direct investment levels would actually still be far below the world average. It also suggests that China's exports levels are still modest relative to the real size of the Chinese economy (only 10% of GDP). Yet, it already has the third largest trade volume in the world, recently overtaking Japan. On the other hand, it also is not likely that China can continue to take market share in manufactured goods as rapidly as it has in the past. Globally, it already dominates in many categories - i.e. portable computers, cell phones ... etc.
Subject to the nearer-term dangers of busts, bank problems, countervailing trade actions ...etc., China still ultimately stands to accumulate much more economic power over the long-term. But, crucially, this perspective of China also undergirds a point made earlier. China's influence upon the world is already large in relative terms. If it sneezes, the impact will now be felt around the world.
4. Chinese Fireworks and Two Reserve Currencies
According to US Treasury Department statistics, Asian surplus countries (China, Japan et al) own a lot of US treasury bonds (over $1 trillion worth) accounting for a significant part of the float. As is well known, these holdings are predominantly official holdings, making up for the greater share of foreign assets custodied by the US Federal Reserve. (See Figure #1) These flows are relatively large, certainly so seen in proportion to US M1. Of course, all is rosy as long as this foreign investment keeps rolling in, whether purchases of treasuries or any other type of fixed-income security. It helps keep interest rates low and the US dollar higher than it might otherwise have been. However, foreign treasury holdings are now so large, as are US dollar foreign currency reserves around the globe, that one has to wonder what will happen if ever a cessation or reversal of these flows were to occur. Stranger things have happened.
We cannot forecast when any such development might occur. But, we can state two facts. For one, every single imbalance of the magnitude being witnessed today, ever before in modern financial history, has at some point been followed by a mix of currency crisis and economic slowdown for the recipient country. No exceptions.
The second fact we think is even more critical: Never before has such a huge chasm occurred between the country of the world's reigning reserve currency and a newly-industrializing country (NIC) ... especially so at a time that an alternative reserve currency, the euro, has debuted on the world stage. This presents some "cannon-powder" vulnerabilities for both competing reserve currencies - the dollar and the euro - which are both floaters. The former is vulnerable to a mass exodus of portfolio capital, the latter to a massive influx. Why? If bullying comes to shoving, countries with big surpluses and reserves (such as China) logically will be more inclined to switch between the reserve currencies, moving from the weaker to the stronger. Should a crisis hit, repatriating capital back to the Yuan or yen would be unattractive. It would drive up these currencies while magnifying losses on existing holdings in the depreciating reserve currency, the US dollar. That was the dilemma Europeans faced in 2001 - 2004. After pouring capital into the US (both FDI and portfolio flows) during the "new paradigm" years, Europeans could only escape back into the euro. As this trend reverted, it helped drive up the euro against the US dollar, creating further exchange losses for Europeans.
It will be different when Asian portfolio capital reverts. Asia has options. The Chinese may not lose as much on the US dollar and its bond positions as some theorize. A major new currency bloc, with deep liquidity, has opened up in the meantime. They can choose to leave their currency notionally fixed to the USD or move their reserves to the euro. Even more effective, they can do both. And, as China is not as philosophically allured with the North American system as were some of the European players (nor beholden militarily) they may have less compunction about doing so. We may be getting far-fetched in our worries. But they are not fairy tales ... rather real possibilities.
Conclusions. No Reason to Yawn on the Yuan.
America and other countries needs oodles of inexpensive oil, bargain t-shirts, the latest Nike sneakers, copious and cheap credit and ever inflating housing prices. To not have any of them would cause hardship and an identity crisis. We therefore doubt that the US will voluntarily rectify its imbalances. Any chastening will likely come from outside. That suggests that any adjustment, when it comes, risks being disorderly.
The US and other countries are vulnerable. A sharp rise in interest rates would be sure to trip consumer spending and bring housing bubbles to a halt. Just such a rise is possible if China is forced into the corner to revalue the Yuan. China stands to continue its program of rapid expansion and can be expected to continue gaining economic power over the next decade. Just as the US experienced a number of economic busts during it early days, China will likely also. However, as we have briefly shown, any rumblings in China are now likely to be felt around the world.