Friday, December 4, 2009

Where the next billionaire will strike it rich

A lot of print space has been reserved for stories on the valuation of the Chinese currency lately, but I haven’t read the same conclusions that I draw from the subject. The media writes stories in which “experts” pronounce that a cheap Yuan is “stealing” jobs from our economy. In some respects this may be true, but I believe that the dollar-Yuan currency situation is a mixed bag for the US and is bound for only one result: the same experience that China’s Asian neighbors had in the currency crisis of 1997 when their fixed-exchange rate policies failed and their currencies changed course rapidly. That outcome produced wealth quickly for the speculators who put on the right bet (that the Asians’ exchange rates would devalue quickly), including a household name, George Soros. I believe a similar result is likely to happen with China, a failure of their fixed exchange rate policy followed by the rapid appreciation of the Yuan, which will produce the very rapid rise of the next billionaire.
First, I want to begin with an elementary lesson on international trade so that anyone who is reading this (still) can understand what I’m talking about. Currencies are a two-way street: they can be priced in foreign currency per domestic or domestic per foreign. For example: today, I can get roughly 0.67 Euro per dollar that I put up or, if I have Euro, I can get $1.48 per Euro. When we start applying the word “value” to currencies it either means relative to what we think it should be or what it formally was. Another example: the last time the Euro and the dollar were evenly valued was at the end of 2002. Since then the Euro has appreciated against the dollar, meaning it takes more dollars to get one Euro. Likewise, if we are talking in terms of dollars, the dollar has depreciated against the Euro. The effect of this change is: European goods and services (e.g. travel) are relatively more expensive while American goods and services are relatively cheaper. So while it may be more expensive for us (Americans) to travel overseas, it has become easier to sell our wares to the inhabitants of the Old Continent thus producing jobs for export industries.
There are many factors behind changes in exchange rates, but hardly ever will just one be working at any given time. Here is a list of the factors that will (generally) increase the value of an exchange rate: lower historical inflation relative to the other country, higher interest rates (again relative), current account surpluses, lower public debt (or higher public savings), and greater political stability (relative).
So while it is true that China has been manipulating its international currency markets, it’s not completely malicious nor is it a bad thing. First I’ll explain how they do it. One way is not really intentional manipulation: the Chinese produce goods, exporting them to America where they are paid for in dollars. For a number of reasons, namely higher inflation in China, a significant portion of exporters keep their revenue in dollars (further explanation below). Some exporters need to bring their revenues back to China in order to pay for their expenses (or shareholders), they have to repatriate the currency which creates upward pressure on the Yuan. So the People’s Central Bank has developed a calculated way to actively manipulate the Yuan: by printing Yuan to pay for dollars they create a large supply of Yuan and demand for dollars which depreciates the Yuan while appreciating the dollar. The central bank has only gone so far as to keep the exchange rate flat since the summer of 2008, which is known as a fixed exchange rate policy, or a peg.
The situation with the Chinese is not all bad, which goes opposite of what our president or the Treasury secretary would have you think. Because the Chinese are a smart people (fireworks anyone) they don’t just sit on their cash, earning a measly 0%. Instead, they invest their dollar wealth into safe, US government bonds earning a positive (most, but certainly not all, of the time), albeit small return. The net effect is that it allows the US government to borrow much more cheaply (smaller interest paymentsĂ lower deficits) than without this added Chinese demand.
This position has now created quite the paradox for China. As a result of the global recession (save China however) the US has been engaging in very expansionary monetary and fiscal policy. China has had to print Yuan as fast as America has printed dollars to keep the exchange rates in tandem. In effect, this means that China has been importing American economic policies even though the economic conditions in our two countries are dire extremes. The only result of the Chinese authorities engaging in this effective monetary expansion while growing at nearly 10% is a considerable overheating that has stimulated inflation. And they have gobs of it too, e.g. it has been reported that in Shenzhen the housing prices have risen 40% year over year.
But it’s been said that this economic policy is the only politically tenable position for the Chinese government. The Chinese economy is dominated by the export industry and were the central bank to take off the peg, it would be as if they had invited unemployment and a recession into their country. As a country with less avenues of dissension, massive joblessness would create unrest that the Party does not want. So they continue to support their export industry and create jobs while tolerating the inflation that it brings.
Whenever the Chinese stop wanting to tolerate the inflation, that’s when they will drop the peg. [Another reason for them to drop the peg would be if they reversed their policy, deciding they would rather spend their country’s wealth on creating a social safety net instead of lending to the US.] And when that happens, the currency race will be on, and the trajectory of the Yuan is due north. I think that the financial investor who accurately anticipates that event at the right time (not too early, not too late), and also correctly chooses the currency that will depreciate the most relative to the Yuan, will reap an amazingly large and bountiful reward. Just like John Paulson’s enormous wager on housing, I think this economic event could produce the next financial billionaire.