Why Investments In China Will Eventually Be Worthless

by: John Lindauer

Trade is by far the biggest reason money flows from the United States to China - think Wal-Mart (NYSE:WMT). In addition, hundreds of billions of dollars have been invested to buy shares in Chinese companies - think Yahoo (YHOO) and Sino-Forest (OTC:SNOFF).

As a result of the U.S. imports and investments, a lot of Chinese workers have jobs paying increasingly higher wages and China has had years of balance of payment surpluses. China has, to say the least, accumulated a huge stock of dollars and dollar-related assets such as U.S. bonds.

How long can this Chinese balance of payments surplus continue? And what does it mean for American importers? For investors in Chinese companies? For gold and business profits? Part of the answer depends on the yuan/dollar relationship.

The value of the dollar is established in the world's money markets. It floats up and down in response to supply and demand. In contrast, the Chinese yuan's exchange rate is effectively pegged to the dollar by the Chinese government. Our politicians and quite a few “pundits” have been calling on China to “revalue” the yuan upward – to peg the exchange rate between the yuan and the dollar higher so that it takes more dollars to obtain each yuan.

Their thinking is that if it takes more dollars to get enough yuan to buy Chinese products, Americans will buy fewer of them, thus reducing the U.S. payments deficit by sending fewer dollars abroad and, at the same time, redirecting the dollar spending now going to Chinese manufacturers back to United States producers to create desperately needed jobs and tax revenues.

For the past year or so, China has responded to the U.S. political presssure and its ever-growing stock of dollars and dollar assets by allowing the yuan to slowly appreciate upwards against the dollar. The exchange rate is changing, but very, very slowly.

But will this continue? And is encouraging the Chinese to revalue the yuan really a good idea? And what will happen to U.S. asset values and gold if the yuan revalues higher? Even more important, is it possible the yuan will be devalued and why and when will that happen?

And the most important question of all for investors in importing companies such as Wal-Mart or directly investing in Chinese companies such as Sino-Forest or indirectly investing in China via U.S. companies such as Yahoo or U.S. asset managers - is it safe to rely heavily on Chinese imports and make Chinese-related investments?

China’s businesses buy workers' labor and sell their products in yuan. If the dollar exchange rate with the yuan is revalued upward, Wal-Mart and other U.S. buyers of Chinese products will have to pay more dollars to get enough yuan to pay for whatever it is they buy in China. So at least initially, the U.S. balance of trade and balance of payments with China will get worse, not better.

On the other hand, Chinese workers and businesses are thought to have an unspoken understanding with the communist party - the party can govern and restrict personal freedoms so long as workers get higher and higher wages and business gets higher and higher profits. So far the understanding is holding despite thousands of local protests, huge corruption, and the virtual total absence of the rule of law as it applies to business and investments.

Whether the Chinese balance of payments gets worse or better will depend on the price elasticity of the U.S. demand for Chinese products. That’s economist-speak for how the higher dollar prices will affect the amount of Chinese goods that will be bought with dollars. For example, if the Chinese peg the yuan 30% higher against the dollar and U.S. buyers respond to the higher prices by reducing the quantity of items they buy by 20%, the amount of dollars flowing into China will increase by 10%. And Wal-Mart and others buying in China with dollars will end up with 20% fewer goods to sell that cost them 30% more to buy.

If an upward move of the yuan happens over time, Wal-Mart and the other big buyers of Chinese products may find new and less expensive places to source the items they want to buy. But setting up new factories and finding new suppliers will take time. So initially the U.S. balance of payments will get worse.

Additionally, if the yuan is revalued upward, Wal-Mart and others with small margins will be forced to increase their prices to cover the higher cost of buying things in China to resell in the United States. So the average price of all the things being sold in the U.S. will rise (inflation).

Moreover, the inital price increases will generate pressures for wage increases for American workers and, indeed, will automatically cause some, particularly many government employees and teachers, to get wage increases because they are working under contracts with automatic cost of living adjustments. Then, to the extent paying more for their workers forces governments and businesses to have to charge higher prices and taxes to stay in business, there will be even more inflation as the higher wage costs push up prices.

Perhaps all of that is the price the United States must pay to get jobs away from China and back to America. But will paying higher dollar prices and sending even more dollars to China cause more jobs in the United States? Not likely. Wal-Mart and other importers are more likely to move the buying they are now doing to China, and the jobs that result, to other low wage countries such as Philippines or Thailand (and maybe India and South Africa someday, but not now because of their overly regulated economies and corrupt bureaucrats).

So what are the probable effects on the United States if our politicians actually succeed in convincing China to revalue the yuan upward? They are all bad: Inflation, a bigger U.S. balance of payments deficit, and few, if any, additional jobs and profits in the United States.

But there are three other alternatives that are even more ominous: 1) That the yuan will be devalued instead of revalued upward, and/or 2) that China will increasingly sink into political chaos and upheaval such that both U.S. investors and buyers such as Wal-Mart lose their ownership positions and suppliers, and/or 3) that China's increasingly kleptocratic government will adopt a Russian-like policy of seizing foreign ownership interests via spurious tax claims and phony court cases.

What is the risk of one or more of these things accelerating - and is it time for importers and investors pull out?

Change in 2012

Today, China is a big wild card in our economic deck and its policies cannot be predicted: Its highly authoritarian leadership changes in 2012. The new leaders may order its central bank to let the yuan continue to very slowly increase in value against the dollar in response to the past calls from our politicians. But more likely they will do just the opposite.

Recent reports from China suggest a major economic downturn may be underway, with idled factories and laid-off workers. If so, the Chinese government might stop the appreciation of the yuan, and even reverse it, to encourage customers from the United States and others to buy more from China so that China's workers can go back to work. That’s the classic “beggar thy neighbor” policy of attempting to use exchange rate changes to increase jobs in one country by taking business away from other countries.

If I was a currency trader or importer or commodities exporter and had to bet, I would bet the yuan will not be allowed to change much against either the euro or the dollar - at least until after the 2012 party congress installs the next generation of Chinese leaders.

But after the party congress, all bets are off. No one knows who the next batch of leaders will be or what policies they will change or how soon they will act or how the Chinese public and military will react to them.

Like the similarly authoritarian governments of Tunisia and Romania, the party's leaders will continue doing basically the same things as their predecessors - right up to until some outraged victim or ambitious army general triggers the revolution. Then the Chinese supply chain will collapse along with the value of most China-related investments. Then where will Wal-Mart buy cheap goods and who will own the Chinese companies, and how high will gold go?

Conclusion: At some point in the coming years, investments in Chinese business will become relatively worthless and gold will go up because of the great uncertainty the Chinese chaos will cause. Anyone doing business with China or investing in China would be well-advised to fully hedge their exposure.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.