Let’s talk about the yuan from China’s perspective to better understand what currency policies are to be expected. A gradual appreciation of the yuan, if managed correctly, can help China contain inflation, strengthen foreign relations, shift its economy to one that is more domestic driven, build a path of making the yuan a reserve currency, and reduce the cost of imports for the Chinese consumers. But allowing a sudden big jump in the yuan will have dire consequences on the Chinese economy and, thus, is not to be expected in the near future.
Firstly, the decline of the euro as a result of the debt crisis has foreshadowed a bleak export environment for China as Europe is currently its biggest export destination. Europe has helped to cushion a drop in China’s exports after a drastic deterioration of the US economy. But the future of this export market is worrisome for China, as the yuan has already strengthened 17% against the euro this year. Just yesterday, Citigroup said that China would face “strong headwinds” in the second half of the year. Thus, further allowing the yuan to strengthen sharply against the euro would be an idiotic, if not suicidal, move for the Chinese.
Currency volatility is very disruptive to export oriented nations like China. Commonly accepted economic theories that stress the benefits of a freely floating currency apply mainly to the West and industrialized nations. Huge currency fluctuations can undermine the stability of emerging economies through their important export sector. Think about it, if you were to consider building a factory in Indonesia that manufactures tires for export with a profit margin of 8%, an important consideration would undeniably be how volatile the Indonesian rupiah is. You would probably hold off on your investments and consider other options if the rupiah has a tendency to fluctuate 30 percent or more in any given year. Your export business could run at a loss if the rupiah goes in the wrong direction. Thus, currency stability has a strong influence on foreign investments into emerging markets and is positively correlated to the health of their export oriented economies.
The concept of decoupling that revolves around the view that the Chinese economy could hold up despite the turmoil in the West was popular prior to the financial crisis. But it was proven to be a myth when China’s economy were deeply impacted and its stock market tumbled more sharply than the US did in 2008. Many factory workers lost their jobs and ended up on the streets. The lesson has helped China understand that it cannot afford to risk a substantial slowdown in its export sector again. Moreover, keep in mind that income from exports is also a key driver to China’s domestic consumption.
Most would agree that the Chinese consumers have gotten much stronger than they were decades ago. But China is still not quite ready to transform itself into a domestic driven economy. It still has some of the highest savings rates in the world due to weaknesses in its health-care and retirement systems. People tend to save when they only have their savings to rely on when they become sick or old. Chinese consumers will continue to save for the rainy days and people should understand that a nation’s spending habit does not just change overnight.
China being the world’s third largest economy with a GDP of about USD$8.8 trillion often makes the news headlines. But what people need to understand is that about 20% of the world’s population lives in China and that means the overall economic output above is being shared by more than 1.33 billion people. That translates into a per capita GDP of merely $6,600 for China in 2009. The figure is miniscule when compared to the per capita GDP of the US that stood at $46,400 in the same year. Some economists will be quick to point out that the welfare of the Chinese people are worse than what the numbers above depict, as China has a low personal income share of GDP. China is a good example of why sometimes using the per capita GDP as a measure of standard of living can be inaccurate.
Unlike many developed nations, the disparity of income in China is huge despite 300 million people being lifted out of poverty during the past three decades as a result of the Chinese communists’ embrace of capitalism. In many parts of the country, especially in the rural areas such as Shaanxi, Gansu, Yunnan, Guangxi, and Sichuan, many people are still living in poverty and struggling to make ends meet. Thus, the Chinese government needs to consider its social responsibility whenever it makes important policy changes such as the revaluation of the yuan. Moreover, any major disruption to the stability of the Chinese economy may cause social unrest which is the last thing that China needs.
Currency policies aside, the increased cost of labor has already put China’s export sector at risk. Workers at many manufacturing plants have been demanding for higher wages and better working environments. Recent strikes at companies such as Toyota and Honda have forced companies throughout China to increase wages for workers. For instance, Honda agreed last month to a 24 percent raise for workers at a parts plant in Guangdong and Foxconn Technology Group will double pay in Shenzhen after the multiple suicide incidences. According to the Ministry of Human Resources and Social Security, more than 20 provinces and municipalities plan to raise minimum wages this year. Henan, a province with about 100 million residents, is raising its minimum wage by 33 percent.
The Chinese government has also been imposing more health-care, retirement, and other benefits requirements on companies doing business in China. The staggering cost of labor may soon bring China’s status as the “world’s factory” to an end.
In addition to the rising cost of labor, the disappointing stock market is another reason why China would not allow the yuan to make a huge leap. The Shanghai Composite index has plunged more than 26 percent this year, making it one of the worst performing stock markets in the world. A significant yuan appreciation that can potentially choke off China’s export will not play well with the market.
If you step back and think about it, the need of a gradual appreciation of the yuan by the Chinese is similar to our administration’s insistence of the benefits that come with a delayed withdrawal of our stimulus measures. Both of them need to be done, but in a tactful and timely manner. Any drastic actions by the governments can potentially put the respective economies into a downward spiral and do the global economy no good. Thus, we should not pressure the Chinese to make their yuan “go up significantly” as much as other nations are not forcing us to stop printing money and continuing to run up our huge national debt that is already in excess of $13 trillion (see here)!
Disclosure: No position