Progress has stalled in the so-called ‘currency wars’

Progress has stalled in the so-called ‘currency wars’

Last week's G-20 summit ended with only modest progress in the so-called 'currency wars,' after global leaders agreed to study the problem for another year and develop new guidelines to tackle serious trade imbalances. Here, David Birnbaum gives his own take on what's going on.

Economics is aptly called the 'dismal science.' After all, not many studies can achieve absolute boredom, total depression, and complete confusion while simultaneously engendering unrestrained fear.

Truly economic textbooks and articles should be treated the same way as cigarettes packs, with a large notice on the cover: "Reading this can be injurious to your health."

Don't say I didn't warn you.

The experts are telling us that the US and the China are about to enter into a currency war, by implementing conflicting policies which may well have ruinous effects on the global economy.

This is not exactly true. The reality is that both the United States and China are implementing identical policies, which may well have ruinous effects on the global economy.

The two countries have joined together, albeit unintentionally, to solve their structural economic problems by devaluing their currencies and by buying massive amounts of US government debt. Having created this accidental Sino-American strategy, each is accusing the other of acting unfairly.

The China case
Chinese economic growth is based on export trade. Marxist rhetoric notwithstanding, China operates a classic, beggar-thy-neighbour mercantile trade policy, importing raw materials and exporting manufactured goods.

Much like 18th century Britain and France, China subsidises its exports of manufactured goods while restricting imports. It is not by accident that the world's largest garment exporter also maintains one of the world's higher tariff barriers restricting garment imports.

The key to China's mercantile policy is its ability to undervalue its currency. This serves to reduce the price of exports while at the same time raising the price of imports. In this regard, as any Asian garment exporter will tell you, China has been very successful - actually too successful.

China has a problem. It has built up this enormous pile of US dollars which now sits there doing nothing. Actually, worse, these excessive currency reserves are now causing increasing disruption not only to its neighbours but to its own economy as well.

The Chinese government cannot use the money in China because it would first have to convert dollars into Chinese currency - which would automatically revalue the yuan against the dollar.

Nor can it use the money to buy overseas assets. Ironically, while a billion dollars will buy a great deal, a trillion dollars will buy little or nothing because the things you would want to buy - Microsoft, Exxon, Boeing etc - are not for sale.

In fact the only home for a trillion dollars is government debt, which is why China now is the world's largest foreign holder of US government bonds.

The greater problem is the need to pay Chinese exporters - actually the exporter's bankers ­- for all the foreign currency they receive, without converting those dollars to RMB. The Chinese solution has been to quarantine the money - take the dollars from the banks and replace the dollars with Chinese yuan-denominated bonds at the official, inflated US dollar rate.

Here is the real killer. Issuing government bonds is the same as printing money, which is very inflationary. Calculating the value of the bonds at their inflated US dollar rate is the same as printing cheap money - which makes the whole process even more inflationary.

The result is what economists term demand-pull inflation - a case of too much money chasing too few products and investment opportunities - where prices, particularly asset prices such as stocks and property, rise out of proportion to their real value.

To counteract the move towards inflation, the Chinese government has tried a number of monetary policies, the latest being increasing interest rates. The logic here is that by raising the cost of money, people will borrow less. As we will see below, therein lies the next and greater problem.

The US case
The US is in poor economic shape. Unemployment is high. Banks are afraid to lend money to anybody but the largest AAA rated corporations, who do not need to borrow because they are already sitting on huge piles of cash.

To make matters worse, the US government cannot pump money into the economy in the form of infrastructure projects which would lead to increased job opportunities, because this is not politically feasible.

Enter the Federal Reserve (the US central bank) which has embarked on a policy of quantitative easing - the Federal Reserve Bank buying US government and other bonds - which translates as printing money - big time.

The logic here is that quantitative easing will lower the value of the US dollar, which will reduce the price of exports while at the same time raising the price of imports (where have we heard that before?), while at the same time reducing long-term interest rates which will make additional funds available to ease the flow of borrowing.

The point is that the US and China have joined together to create monetary policies based on depreciating the dollar and the yuan while buying large amounts of US government debt.

As I warned at the outset - absolute boredom, total depression, and complete confusion while simultaneously engendering unrestrained fear.

That was the introduction...here comes the fun part
Originally, China's pile of US dollars was the result of rising exports to the US. However, the new Sino-American joint initiative has brought a new dimension which makes the problem far more serious than either side recognised.

Quantitative easing provides US banks with additional funds to lend out. However, providing additional funds does not necessarily mean banks will lend out those funds, particularly at a time when the only safe borrowers - the major corporations - are already awash with cash.

Furthermore, even if the banks were willing to lend out those funds it does not follow those loans will go to US based investments. Remember US banks are all global operations.

When you think about it, at a time when the US economy is stagnating, US interest rates are heading down, and the US dollar is heading down, the US might not be a good risk.

Better to go outside the US and put the money in a country with a large and rising economy where interest rates are rising and the value of the currency is rising. Under the circumstances, what better place than to put this new money than China?

All of which leads us to a perfect circle.

  • US dollars flow into China
  • China returns the US dollar surpluses to the US
  • US banks lend these US dollars for investments in China
  • US dollars flow into China...

...so the Chinese pile of US dollars grows.

Collateral damage: innocent bystanders' victims
If this were a problem involving only the US and China, we could all relax and watch the two giants duke it out. Unfortunately, the Sino-American joint policy seriously impacts on everyone else.

The other industrialised countries (notably Japan and the countries of the EU which also rely on exports) have seen their currencies move up, making their exports less competitive.

Developing countries that produce light consumer products such as garments find it increasingly difficult to compete with China because their currencies are forced upward in comparison with the both the Chinese yuan and the US dollar.

At the same time many of these countries have seen tremendous inflow of hot money - people and companies looking to make a fast buck by taking advantage of countries with strong economies, high interest rates, and upward moving currencies.

This situation cannot continue indefinitely. There must be a solution

Moving towards a solution
For the past month, neither the Chinese nor the US have been able to work effectively towards a solution. Both sides were deeply involved in their respective elections.

Regrettably, during political campaigns, rhetoric and posturing become the order of the day.

This is where both the Chinese and US governments stand up and say: "This is not my fault. The problem is with the other guy who has selfishly put his narrow national interests above the well being of the rest of the world."

Chinese solo: "If only the United would raise their interest rates."

US solo: "If only China would limit the size of their foreign currency reserves."

Duet: "We must all work together to force the selfish ones to change."

While the US elections are over, we must now wait for the Chinese leaders to elect their new leaders before serious consideration can be given to the world economy.

The end of the problem
Fortunately the problem will be solved, simply because the current situation is unsustainable.

China is beginning to face demand-pull inflation, which will cause serious economic disruption and hardship to the people with lower income. 

Quantitative easing has added two new problems to the Chinese dilemma.

  1. Whereas in the past the Chinese had only to keep parity with a stable currency, they must now maintain their undervalued exchange rate against a currency which itself is being devalued.  
  2. Between now and June 2011, the Federal Reserve plans to buy bonds totalling $600bn. This is equal to 100% of the US government's needs to turnover its debt. This removes any leverage the Chinese might have had to affect US policy.

The Chinese government is running out of options.

As the pile grows higher, the problem becomes increasingly more serious. As of October 2010, the Chinese foreign currency pile totalled about $2.6 trillion - equal to 53% of China's GDP. Of this amount, $1.7 trillion is denominated in US dollars. That pile is growing at the rate of a $1bn a day. 

China Foreign Exchange Holdings
    2010 2011 2012
Total Foreign Exchange PCT $2,650,000,000,000 $3,010,000,000,000 $3,375,000,000,000
US$ Holdings 65% $1,722,500,000,000 $1,956,500,000,000 $2,193,750,000,000
EURO Holdings 26% $689,000,000,000 $782,600,000,000 $877,500,000,000
UK Pounds 5% $132,500,000,000 $150,500,000,000 $168,750,000,000
Other 4% $106,000,000,000 $120,400,000,000 $135,000,000,000
Foreign Exchange PCT GDP   53% 55% 56.6%
Potential Exchange Loss US$ 20% $344,500,000,000 $391,300,000,000 $438,750,000,000
Exchange Loss PCT GDP US$   6.9% 7.1% 7.4%
Potential Exchange Loss US$ 30% $516,750,000,000 $586,950,000,000 $658,125,000,000
Exchange Loss PCT GDP US$   10.3% 10.7% 11%

The question is no longer how the Chinese can safely extricate themselves from this mess. There is no "safe" way.  There will be a loss. The only question is just how big.

According to current estimates, the Chinese yuan is undervalued by 20%. Should the yuan be revalued by 20%, the Chinese will take a loss of over $300bn, provided they act this year. Next year the figure rises to nearly $400bn.

Furthermore, this does not take into consideration the effects of the sale itself. Money is a commodity: the greater the supply, the lower the price. At the end of the day, the loss might well be closer to 30%.

Currency wars? & the garment industry!
The situation is unstable. What is true today might not be true tomorrow (actually it might not even be true today). As I see it, there are two possibilities:

  1. Despite the serious nature of the problem, China may well solve its problems while still maintaining a competitive edge. Personally, I would not bet on that.
  2. China's solution may not allow it to maintain its competitive edge, or worse it might not be able to solve its problems at all. Personally, I would not bet on that either.

For us garmentos, the smart move is to hope for the best, but to take out insurance against the worst. I think increased diversification away from China might still be the best move.

David Birnbaum is the author of The Birnbaum Report, a monthly newsletter for garment industry professionals. Each issue analyses in-depth US garment imports of four major products from 21 countries, as well as ancillary data such as currency fluctuations, China quota premiums and clearance rates.