Global Inflationary Pressures Likely If Yuan Unties From Dollar

I concluded the last installment of the Asia tour with a hint at identifying investment opportunities in this region. I will identify opportunities before these installments are finished, but doing so now may be a little premature, especially with recent occurrences and developments.

Everyone in this region is concerned that a slowdown in the United States will adversely affect the economies of Southeast Asia. In the past, the US has accounted for a considerable amount of the exports coming from this region. The United States still accounts for a significant amount, but for the first time ever the European Union Union has accounted for more. Exports to the United States have decreased from 34% of net exports to 20% respectively. At the same time, exports to other regions have increased measurably, and this offsets the impact of a weakening US economy on this region.

That's not to say that Southeast Asia won't feel any heat from a US slowdown; 20% is still a big number. The point is, because of the diversity this export market has achieved over the past few years, the impact will be far less than it was in 2002, for example.

The main issue for regional governments here is curbing inflation. The governments do not want prices to get out of control, but they are losing their grip. China has already attempted to thwart inflation by halting lending practices altogether for the remainder of 2007. However, government imposed price ceilings that manufacturers are allowed to charge for their products are at capacity, so inflation is distorted already and poised to increase. Many countries in this region are expected to lift pricing controls next year. That means that inflation rates in this region are likely to increase abruptly going into 2008. This will lead to further interest rate increases in China, and probably the surrounding region.

Liquidity is also a major concern because it is fuel for inflation. This region is flush with liquidity. Now, many governments are issuing bonds to take money out of the economy; corporations can't do it because the price of debt has gone up too much. (This may be very important to the USA in the future by the way, so make careful note of this: Governments can make more money when Interest rates are higher). They are doing this in an effort to curb the rate of growth in the economy. In addition, China, amongst other countries, are considering mandates which limit the amount of foreign investment into their respective countries; foreign equity investments have been robust in recent years. They are doing this in an effort to curb liquidity and to curb inflation too, not to dampen relations.

We have already seen the swift hand of the Chinese government when they decided to halt lending practices for the remainder of the year, so we we should not be surprised to see sudden caps on foreign equity investments into China implemented immediately if economic growth continues at such a robust pace. Brace for this. If inflation continues at higher than expected levels (pressures exists everywhere already) mandates are almost sure to come.

This leads us to another question, something that US policymakers have been vying for for quite some time. Policymakers have insisted that the Chinese Yuan was artificially low in comparison to the dollar. Many Policymakers want the Chinese government to allow The Yuan to increase in relation to the dollar by allowing it to fluctuate on the open market; in turn these Policymakers believe that US Products would become more competitive.

We better watch out what we wish for.

The untying of the Yuan from the US dollar would further decouple China and other Southeast Asian countries from the United States. In addition, untying the Yuan will likely cause a spike in inflation in the United States. The last thing that US manufacturers want to see is currency appreciation from southeast Asia, China in particular.

If these currencies increase, the cost of labor increases, raw material costs are already increasing, and the prices of US-based products manufactured in Southeast Asia will increase accordingly. This is what's called, core inflation. We're not talking about food and energy here, we're talking about basic goods. Take a look at all the things in your household. Simple appliances, bathroom tissue, your pen and paper, most of these and other products that you can reach out and touch are manufactured in this region. If the cost of doing business in this region increases because of simple currency appreciation your cost to buy these goods and services will increase accordingly, and that will happen around the world as well.

Global inflationary pressures are likely if the Yuan unties from the Dollar.

The untying of the Yuan will hurt our economy drastically by increasing inflationary pressures. We cannot let this happen. From a policy standpoint, the argument that US made products lose competitive advantage because the Yuan is tied to the dollar instead of being free to trade on the open market is clear. However, our policy makers must understand that the people in this region have little if any interest in buying US-made products. Globally we may be a little more competitive, but if we suddenly get on par with goods manufactured in this region, the global inflationary impact will cripple the world economy.

Southeast Asia is where we find cheap labor, but if labor prices increase with simple currency appreciation, all bets are off.

People in this region loves the United States because United States consumes the products that they make. But they have no interest in making United States stronger by buying products from the United States. Policy efforts to untie the Yuan are not sound. Not only will the US manufacturers based in Southeast Asia be faced with higher manufacturing costs, but there will be no change in net exports to this region based on the same, and we will still not be competitive in other foreign markets.

Inflation will continue to be a problem, and Southeast Asian governments will continue to try to moderate capital investments, so a slowdown in this region is all but assured near term, as I have already mentioned. However, that's not likely to last very long. Opportunities will arise. In the next installation we will talk about attractive investments in this region.

For now, the US needs to be careful. The Fed needs to be cautious, and policymakers need to re-evaluate their stance on the Yuan. Otherwise, core inflation could start to rise measurably. Remember, the strong hand of the Chinese Government moves fast!

Comments

[Foxco]

Yes, inflation and the untying of currencies to the dollar are scary! But necessary. If we truly want a global economy then we cannot continue this unbalance for much longer. The currency imbalance is destroying the idea of comparative advantage and making the global economy more instable. The idea that cheap labor only resides in certain parts of the world is counter to the convergence of wages that must take place as our economies become more interdependent. The untying of the Yuan will make Chinese goods more expensive but it will also make some US goods cheaper. I am disturbed that this author claims that people in Southeast Asia have no interest in buying US-made products because they don't want to make the US stronger. What? Since when does anyone care where cheap goods come from? If you reverse this logic, then why the heck do so many Americans buy Chinese goods? Who said we have any interest in making "communist" China stronger? The only benefit to keeping their goods cheaper is that it allows Americans to consume more than they produce. Why this is a problem really should be a no-brainer. Even if you believe that our unbalanced consumption is not a problem, at least consider the instability that it creates. “The strong hand of the Chinese Government” is the result of this enormous imbalance that we have allowed. The longer our currencies are tied together, the longer we have to worry about the actions of the Chinese Government. Currency values should be market driven, not government controlled. Furthermore, labor costs should also be market driven, which they are not. The undervalued Yuan makes Chinese labor too cheap, and US labor too expensive. The result is unbalanced growth in labor-intensive goods production in China, and over-paced loss of labor-intensive goods in the US. Its true that sudden revaluation to get us on par with China would probably cripple (short-term) the world economy, but that doesn’t mean gradual revaluation is not necessary. The point is that the status quo is not sustainable, and the longer we let it continue the greater the consequences.

[Thomas Kee]

Fox:

The cultures are different. Unique products like Ipods, sure, but if they have an option of buying a US product or a Product made by their homeland, their will choose the home based product every time. With that, we don't make very many things that could compete with their prices anyway. If we did, the governments would impose tariffs so they didn't compete.

Gradual decoupling may be good, yes, but these Governments work swiftly.

[Doug Roberts]

Hi - Making claims like "Global inflationary pressures are likely if the Yuan unties from the Dollar" would be more acceptable if there were some reason explicitly supporting such a claim. - Doug

[Thomas Kee]

Companies that operate in China will have to pay more for their labor if the Yuan increases in value against the dollar. That means they will have to charge more to us to maintain margins. That means inflation.