Revaluing the Yuan

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This article discusses the valuation of the yuan relative to the US dollar. For more information on the currency, see Chinese Renminbi (CNY)

Many argue that the Chinese currency is undervalued relative to the U.S. dollar due to the Bretton Wood II system, yet some senior Chinese leaders have repeatedly stressed that Yuan is not undervalued, and an appreciation of the Chinese RMB could not reduce the trade imbalance between the U.S. and China. There is likely no definite answer academically or economically of what an equilibirum Yuan exchange rate should be. Since the beginning of 2010, undervaluations of anywhere between 0% to 40% have been reported by the press.

The U.S. possesses several mechanisms to seek a rebalancing of this exchange rate, including working through the IMF and the WTO. A higher priced Chinese currency could help U.S. exports to China, but harm the real estate market and interest rates in the U.S. On the other hand, a currency revaluation will yield a relatively lower cost for raw materials for Chinese manufacturers.

The Treasury Department and Congress continue to wring their hands about the value of the Chinese dollar. Savvy investors may wish to look beyond the sound bites to see how a revaluation of the Chinese currency will affect U.S.-China trade and particular companies. There may be significant winners and losers from a revaluation, especially in the finance, retail, and consumer goods sectors. Even investments in companies wholly unrelated to China could be affected due to their exposure to worldwide currency risk or interest rates.

Which Companies Would Benefit from a Yuan Appreciation

• U.S. manufacturers of capital equipment, such as Caterpillar (CAT) and Deere (DE), because customers can be somewhat price-sensitive, but not driven solely by brand name.
• Wholesale food exporters like Archer-Daniels-Midland Company (ADM), DANONE, and Chiquita Brands International (CQB), who face less domestic competition due to higher local prices.
• Western commodity manufacturers, such as steel companies like Nucor (NUE), Arcelor Mittal (MT), and Wheeling-Pittsburgh (WPSC), who face less competition due to higher Chinese prices.
• Chinese airlines, such as China Eastern Airlines (CEA) and China Southern Airlines Company (ZNH), who pay less in Yuan for airplanes and aviation fuels.

Who Might be Hurt by a Yuan Appreciation

• Investors holding a lot of Treasury Bills or U.S.-dollar-denominated bonds.
• Mortgage providers like Countrywide Financial (CFC), Wells Fargo (WFC), and Federal National Mortgage Association (FNM) would face higher rates, which would decrease their business volume
• Mass-market retailers Wal-Mart Stores and Target Stores rely on volume sales of lower-margin goods, many of which are imported from China. A Yuan revaluation will make the price of Chinese imports into the United States rise, impacting Target and Walmart's profitability.
• Electronics producers such as Dell (DELL), Hewlett-Packard (HPQ), Motorola (MOT) and Nokia (NOK) who built factories in China and employed Chinese workers to manufacture their products for the U.S. market.
• Utilities like FPL, TXU and SEMPRA ENERGY (SRE) would have a higher cost of capital.

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Drivers: Sources of Pressure on the Renminbi Exchange Rate

There are multiple forces that could impact China in its decision about raising the value of the renminbi relative to the U.S. dollar:

• High-level U.S. officials, including Treasury Secretary Paulson and Federal Reserve Chairman Bernanke, have traveled to China and urged a revaluation of the renminbi in light of China’s foreign exchange surplus. U.S. officials have argued that a higher-value renminbi would help China by reducing its need to buy over-priced dollars to support its currency and by enabling smoother currency fluctuations through a reliance on a broader basket of currencies to comparatively value the renminbi. Also, a higher value renminbi might slow the Chinese economy, which has been growing nearly 10% per year, and thus prevent skyrocketing inflation there. Thus, one reason China might revalue the renminbi and liberalize its exchange mechanism is to assist its own economy.

• U.S. Congressional leaders have proposed tariffs on China if it does not cease subsidizing the renminbi through what these Congressmen deem to be an artificially low exchange rate. China may consider raising the value of the renminbi enough to forestall any new U.S. tariffs on Chinese goods. On the other hand, Chinese leaders may not want to be seen as kowtowing to another country or engage in any behavior that might slow the Chinese economy and related job growth because unemployment and accompanying domestic unrest is one of the Chinese government’s worst fears. Additionally, China could file a grievance with the WTO if the U.S. tariff lacks a sufficient legal basis under the WTO rules.

• The International Monetary Fund (IMF) is charged with advising its members on their currency and exchange policies. In its exchange rate policies adopted in 1977, the IMF specifically cited “protracted, large-scale intervention in one direction in the exchange market” as a development that should prompt the IMF to discuss exchange rate policies with the member country. Some economists argue that the large increase in China’s reserves over the past three years warrants such IMF attention.

• A dispute could be filed against China before the World Trade Organization (WTO) Dispute Resolution Body. Article XV, paragraph 4 of the General Agreement on Trade and Tariffs (GATT) requires that parties shall not frustrate GATT by the use of "exchange action." In order to pursue such an action, the U.S. would first need to prove that the exchange rate is undervalued and, second, that as a result competition is unfair. It should be noted, however that WTO will defer to the IMF in certain monetary matters. Article XV, paragraph 2 of GATT provides that:

"In all cases in which the CONTRACTING PARTIES are called upon to consider or deal with problems concerning monetary reserves, balances of payments or foreign exchange arrangements, they shall consult fully with the International Monetary Fund. In such consultations, the CONTRACTING PARTIES shall accept all findings of statistical and other facts presented by the Fund relating to foreign exchange, monetary reserves and balances of payments, and shall accept the determination of the Fund as to whether action by a contracting party in exchange matters is in accordance with the Articles of Agreement of the International Monetary Fund, or with the terms of a special exchange agreement between that contracting party and the CONTRACTING PARTIES.”

Thus, the WTO could not contravene any IMF findings related to the appropriateness of China’s exchange mechanism. If the United States pursues a revaluation of the renminbi through the WTO and/or the IMF, this has the advantage of multilateralizing the pressure on China and removing any Chinese hesitance to kowtowing to a particular country; however it may also be a slower, more politically fraught process as other IMF and WTO members try to use the situation for their own political gain in their relations with China.

If the Renminbi Is Allowed to Float More Freely and It Rises in Relation to the U.S. Dollar

One impact of a rising renminbi relative to the dollar is that U.S. imports into China will become relatively cheaper. This would spur the sales of U.S. imports that are highly price-elastic, such as consumer goods. Imported U.S. consumer goods would suddenly appear to be cheaper to the Chinese consumer, while the price advantage of locally made good would erode somewhat.

However the impact of a change in exchange rate should not be overestimated. For products and services that require large amounts of unskilled or semi-skilled labor, Chinese products will still be significantly less expensive than imported products because Chinese wages are so much lower than Western wages that even a doubling of the value of the renminbi would not make the West a lower-cost provider of some products.

If the U.S. dollar falls in relation to the renminbi, it may be time to consider buying Euros or Euro-denominated stocks, bonds, and indexes. In order to raise the value of the renminbi relative to the U.S. dollar, the Chinese government will likely purchase less U.S. dollars with its foreign exchange reserves. In exchange, one likely currency that China might purchase more of is the Euro, given its large float. As a result, the value of the Euro will climb relative to the dollar. This may lead to more U.S. imports from Europe over time On the other hand, private investors seeking a relatively undervalued currency may invest in more dollar-denominated instruments if the Euro rises too high, thus reducing the split between the two currencies.

China’s financial institutions are still maturing. If the renminbi is valued based on market-driven factors, the volatility this may trigger in its value might be beyond the capabilities of Chinese banks to manage. Thus, while the renminbi-denominated deposits of these banks will rise in value, Chinese banks, such as Industrial and Commercial Bank of China, China Construction Bank, Bank of China, and[China CITIC Bank Co. may be a less attractive.

On the other hand, this will reduce China’s overall money supply because the Chinese Central Bank will be converting less foreign currency into renminbi. Accordingly, Chinese banks may have to be more careful in their loan decisions, which will aid the long term health of China’s financial sector.

The price of Chinese imports into the United States will rise. This will affect the profitability of mass-market retailers, such as Wal-Mart Stores and Target Stores who rely on volume sales of lower-margin goods. Over the long-term, if the renminbi continues to appreciate, this means that major overseas producers such as Nike would shift more of their production to other developing countries, such as Vietnam.

The relatively low value of the renminbi also subsidizes the purchasing power of U.S. households. An increase in the price of Chinese imports, due to a more valuable renminbi, would be the functional equivalent of a tax hike on the U.S. consumer. And this tax would be somewhat regressive, because higher income households may be less likely to buy lower cost imports from China; and, regardless, a smaller percentage of wealthier households’ income is spent on such imports.

In order to support its currency, China may be forced to reduce its foreign exchange reserves. This will trigger a sell-off of dollars and potentially the need for the Federal Reserve to raise interest rates in order to support the U.S. dollar. Until now, borrowing from China has led to low interest rates for U.S. consumers. A change in interest rates would have dramatic effect on residential real estate prices, mortgage lenders and impact housing companies. Companies impacted would include Countrywide, FannieMae, Bank of America, and Wells Fargo.

Without China’s purchases of dollar-based assets, which is how it currently stabilizes the renminbi, the U.S. the dollar would be lower and [Rising Interest Rates|U.S. interest rates]] would be higher. This means that China is subsidizing U.S. interest rates. Both American corporate and individual borrowers and would pay a higher price without the dollar-recycling aspects of Chinese currency policy. Thus, in addition to prospective homeowners facing higher mortgage rates, corporations that rely heavily on debt to finance their business, such as utilities like FPL, TXU, and Sempra Energy would face earnings pressure from a shift in the value of the renminbi.

A rising renminbi would result in the shuttering of marginally profitable manufacturers in export industries in China. This would trigger a significant loss of job and possible domestic unrest in China. In order to combat job losses, the Chinese government may have to resort to increased public spending. To the extent the Chinese government spends on infrastructure, this would benefit companies like Parsons and Bechtel.

If the Renminbi Does Not Rise As Rapidly in Relation to the U.S. Dollar

Some economists have suggested that a strengthening of the renminbi will not make a significant impact in the U.S. trade deficit with China. More influential impacts on the trade deficit are the appetite of U.S. consumers for lower-cost goods and the low savings rate of U.S. consumers combined with ongoing budget deficits.

Because the U.S. has a far lower domestic savings rate than China, the United States is importing surplus saving from abroad to grow and finance its private and public deficits. China is merely the lowest-cost provider of such capital, and a higher-priced renminbi alone will not impact the United States’ appetite for foreign capital investment, and the concordant current account deficits.

China is competing with other Asian economies. As a result, much of the rise of the U.S. trade surplus with China is correlated with a fall in the U.S. trade deficit with other developing economies. Thus, even if the U.S-China deficit could be impacted by an increase in value of the renminbi, offshore production may just shift to another developing country and the U.S. will continue to run the same overall worldwide trade deficit.

Recent data from the U.S. Department of Commerce showing the share of total U.S. imports of selected locations highlights this trend:

U.S. Imports from East Asia

As the graph illustrates, even though total U.S. imports from China increased dramatically, U.S. imports from East Asia (representing China, Japan, South Korea, Taiwan, Hong Kong, Malaysia, Indonesia, Thailand, Singapore, and the Philippines) fell as a percentage of total U.S. imports. This shows that many Chinese exports to the U.S. likely did not impact the overall U.S. trade balance with China because it was a mere shifting of production from one Asian country to another. In fact, imports from East Asia as a share of total imports has been falling since the mid-1990s, despite the growth in U.S.-China trade.

An increase in the value of the renminbi may have little effect on U.S. exports and jobs for several reasons. First, Chinese manufacturers will have more buying power when purchasing raw materials from abroad, thus enabling them to keep down some of their key costs.

Economic studies, such as the 2004 Economic Report of the President by the President’s Council of Economic Advisors, suggest that imports from China have affected few U.S. jobs. This conclusion was reached by determining that most U.S. job losses were in industries where China was not a significant competitive force. In 2005, Alan Greenspan echoed this sentiment in a hearing held by the Senate Finance Committee, stating that “I am aware of no credible evidence that support such a conclusion” that “a marked increase in the exchange value of the Chinese renminbi relative to the dollar would significantly increase manufacturing activity and jobs in the United States.”

In order to allow the renminbi to rise in value, China could establish a more accessible, market-driven currency exchange mechanism. A side effect of this mechanism would be greater capital mobility for Chinese companies and individuals who wish to exchange their renminbi for U.S. dollars, perhaps because they would like to invest in the U.S. capital markets or consider the dollar to be undervalued. The resultant rise of the dollar from these exchanges might offset any benefits accruing to U.S. exporters from a stronger renminbi.

China’s continued buildup of massive foreign exchange reserves creates a significant investment challenge for China’s central bank and its financial sector as a whole. China’s central bank now has over $1 trillion of foreign currency to invest. Recent rumblings in Beijing suggest some of these funds will be put into a special investment fund. On March 9, 2007, the Chinese government announced it would set up a foreign exchange investment company to make better use of its massive foreign exchange reserve. The model for this entity will be Temasek Holdings of Singapore, which manages that city-state’s foreign exchange investment. The new company will be under the direct leadership of the State Council, or the cabinet, instead of the finance ministry. This means that there will be dramatically increased direct Chinese investment overseas through vehicles other than government-backed securities.

Another challenge created by the current, semi-fixed exchange rate regime and its correspondent foreign exchange reserve is the massive availability of credit to Chinese banks. China has been trying to reform its economy, in part, through a reduction in loss-making state-owned commercial enterprises. The availability of massive amounts of cheap credit from the central bank does little to discourage Chinese banks from continuing to lend to these otherwise insolvent institutions and thus pass the insolvency from the commercial entity into China’s banking system.