The Sunshine Report

There is mount­ing evi­dence that a freely float­ing Chi­nese cur­rency will actu­ally drop in value and make Chi­nese exports cheaper. In his con­fir­ma­tion hear­ings, Tim Gei­th­ner espoused the U.S. “Con­ven­tional Wis­dom” that China is an unfair trade com­peti­tor because it manip­u­lates its cur­rency down in value so that its exports are arti­fi­cially cheap. The Con­ven­tional Wis­dom is that a freely float­ing Yuan will increase in value mak­ing Chi­nese goods more expen­sive and help­ing U.S. man­u­fac­tur­ers. But, what if Gei­th­ner is wrong and a freely exchange­able Yuan does the oppo­site of what every­one expects?

Gei­th­ner is def­i­nitely cor­rect when he says that the Chi­nese are cur­rency manip­u­la­tors. After all, the Chi­nese gov­ern­ment decides on Yuan-Dollar exchange rates, and then uses cur­rency con­trols to ensure that tar­gets are achieved. But, what is unclear is that a freely float­ing and exchange­able Yuan will increase in value.

The prin­ci­pal evi­dence sup­port­ing Geithner’s view that the Yuan is too cheap is that United States man­u­fac­tur­ers have been los­ing busi­ness to Chi­nese man­u­fac­tur­ers for a long time. Econ­o­mists that sup­port Geithner’s posi­tion point to per­sis­tent Chi­nese trade sur­pluses and con­clude that cur­rency manip­u­la­tion must be tak­ing place. How­ever, a large cur­rent account sur­plus isn’t in of itself suf­fi­cient to cause the Yuan to appre­ci­ate. For the Yuan to increase in value, investors and Chi­nese cit­i­zens still must want to own Yuan rather than Dol­lars, Yen or Euros.

Yuan appre­ci­a­tion advo­cates ignore under­ly­ing eco­nomic rea­sons that make Chi­nese goods cheap — like near slave wages, cost sav­ings at the expense of the envi­ron­ment, poor worker safety and cheap land. On Sun­day, Feb­ru­ary 1^st, the Lon­don Times reported

“…a grow­ing num­ber of econ­o­mists say…that it is not the exchange rate but years of sweat­shop wages and income inequal­ity in China that have dis­torted global com­pe­ti­tion and sti­fled domes­tic demand.”

China crit­ics who accuse the gov­ern­ment of being an unfair trade com­peti­tor through cur­rency manip­u­la­tion dis­re­gard other facts sug­gest­ing China’s cur­rency is over­val­ued and maybe by a lot.

First, a pre­req­ui­site for a strong cur­rency is a strong gov­ern­ment that is able to main­tain social order. The Sun­day Lon­don Times arti­cle, Vio­lent unrest rocks China as cri­sis hits, describes labor unrest, riots, state cen­sor­ship, vio­lence and class war­fare The unmis­tak­able con­clu­sion of the Lon­don Times arti­cle is that the fab­ric of Chi­nese soci­ety is start­ing to come apart. The arti­cle pro­vides scary and cred­i­ble details of scores of events that under­cut the West­ern image of an all pow­er­ful Chi­nese gov­ern­ment in con­trol of soci­ety. The images pre­sented by the Lon­don Times don’t pro­vide a social back­drop for China which is a pre­req­ui­site for a strong Yuan.

Sec­ond, as reported by the New York Times, unem­ploy­ment is soar­ing among migrant fac­tory work­ers that make up the back­bone of the Chi­nese man­u­fac­tur­ing work­force. Ris­ing unem­ploy­ment and a crash­ing man­u­fac­tur­ing sec­tor aren’t typ­i­cally indi­ca­tors of a cur­rency that is about to appreciate.

Third, investors have been flee­ing China and the flow of export earn­ings into Yuan has slowed. As reported on Feb­ru­ary 2^nd in the Inter­na­tional Her­ald Tribune

“In Shang­hai, cash-rich Chi­nese com­pa­nies are buy­ing high-yield bonds of Amer­i­can com­pa­nies in dis­tress, and bring­ing home fewer of the dol­lars they earn abroad from exports.

And in Hong Kong, wealthy Chi­nese from the main­land are turn­ing up in grow­ing num­bers at jew­elry stores here seek­ing one thing: dia­monds, big ones…

… Chi­nese cit­i­zens are start­ing to send more money out of the coun­try and over­seas investors are pulling money out of China while slow­ing their pace of new investments.

China still has tor­rents of cash pour­ing in from trade sur­pluses, as imports shrank faster than exports in the final months of last year. But that inflow has been nearly bal­anced in recent months by an unex­pected out­flow of pri­vate cash from the main­land and a slow­ing of invest­ment into the mainland.

Offi­cials… have said con­spic­u­ously lit­tle about cap­i­tal flight in recent weeks.”

A sure sign of an over­val­ued cur­rency is cap­i­tal flight. When investors, traders and cit­i­zens believe that a cur­rency is sound, they do not flee to other cur­ren­cies, gold, dia­monds or U.S. junk bonds.

Fourth, many Sino experts believe that 30 years of cur­rency con­trols have pro­duced pent up demand in China’s new mid­dle and upper class to invest out­side of China. While some exporters and entre­pre­neurs have fig­ured out ways to avoid gov­ern­ment reg­u­la­tions and keep their prof­its out­side of China, for the most part, for­eign earn­ings have been brought back to China and con­verted into Yuan. How­ever, if exporters were no longer com­pelled to con­vert their earn­ings to Yuan, and were allowed to freely invest out­side of China, the flood­gates would open and pent-up liq­uid­ity would pour out of China and into other cur­ren­cies. And, the Yuan would depre­ci­ate in value.

Finally, Reuters reported on Feb­ru­ary 2^nd that a Cen­tral Mil­i­tary Com­mis­sion was con­vened and deter­mined that there was “slack man­age­ment” in some of the ranks of the People’s Lib­er­a­tion Army (“PLA”) and that “…[all] mil­i­tary forces should ensure that they “uncom­pro­mis­ingly obey the Party and Cen­tral Mil­i­tary Commission’s com­mand at any time and under any cir­cum­stances”. The Com­mis­sion was con­vened because China faces “…grow­ing unrest and …“mul­ti­ple secu­rity threats””. The Com­mis­sion also called for “absolute obe­di­ence to the Com­mu­nist Party”. The fact that the gov­ern­ment needed to con­vene a mil­i­tary com­mis­sion to make sure that the PLA obeys its orders is sur­pris­ing. China has two major cen­ters of power, the Chi­nese Com­mu­nist Party and the PLA. The Commission’s state­ments indi­cate ten­sion between the two orga­ni­za­tions and the pos­si­bil­ity of con­flict within the Chi­nese estab­lish­ment. Strong cur­ren­cies don’t sur­vive when the Army resists fol­low­ing the orders of civil­ian authorities.

Tim Gei­th­ner bet­ter hope he doesn’t get what he wants and that the Chi­nese don’t make the Yuan freely con­vert­ible or its crash­ing value may be an unwel­come sur­prise to the U.S. economy.