Yuan Way Ticket
News today that China took the first steps to decouple the value of its currency, the Yuan, from its artificially low peg against the US dollar. First, the Chinese central bank devalued the Yuan by a modest 2.1% - the first move in 10 years, and one considered long overdue by many economists. Second, henceforth, the Yuan will be pegged to a basket of international currencies including the Yen and the Euro, rather than the dollar alone. This second change holds out the possibility of more realistic valuations in the Chinese currency going forward, if (or when) the Chinese decide to cut the cord entirely and allow the Yuan to float on the international markets.
This is interesting in a couple of ways. The artificially-low value of the Chinese currency meant (and still means) that the goods and labor produced by the Chinese economy are artificially cheap on the international market, especially relative to the output of the American economy. Much of the disparity remains a result of lower real wages and lower real materials costs. As the Chinese economy has grown, however, these disparities have lessened, but the benefits have not been realized by China’s trading partners because of the dollar peg. The 2.1% adjustment announced yesterday is not nearly enough to compensate for China’s actual economic growth. Still, it is a step in the right direction.
What this should mean for the American economy is an increase in competitiveness of both our labor and our exports. Chinese labor costs just rose 2.1% - still probably not enough to make a major difference in outsourcing, but perhaps enough to introduce an element of uncertainty into the plans of international companies who rely on cheap Chinese manufacturing and other labor. After all, China’s move signals a clear step towards floating the Yuan, exposing the Chinese labor market to the same competitive pressures as the rest of the industrialized world. As economic growth spreads to the consumer economy and demand rises, even the Chinese government will not be able to hold wages down indefinitely. The value of Chinese labor will find its natural level relative to the productivity of its output and will no longer be such a bargain on the world market. This is a good thing all around, and it’s why American governments of both parties have been fighting so hard for currency revaluation for so long.
A related benefit is that Chinese exports became 2.1% more expensive relative to American-made products; or, to put it another way, Chinese consumers just got a 2.1% discount on American goods at no cost to US producers. Again, this is not nearly enough to even start closing our multi-billion dollar trade gap with China, but it is a step in the right direction. American exports remain strong in absolute terms anyway, and the export sector is creating more and better jobs than practically anywhere else in the US economy. Every little bit helps here.
Devaluing the Yuan and breaking the dollar peg also makes US assets less attractive to Chinese investors. This is a mixed blessing, because Chinese borrowing has been enabling the US government to run massive deficits while maintaining relatively low interest rates. The Chinese were getting a good deal because the relatively-low nominal returns on US T-bills were supplemented, in effect, by a currency exchange rate that gave investors more buying power in Yuan than should have been the case had rates been set properly. Here, a 2.1% adjustment is significant, since we’re only talking about returns of 4-5% in the first place.
By removing this incentive for Chinese investors to underwrite American deficits, it is entirely possible that interests rates in the US will have to rise, to ensure the government maintains sufficient capital flows. Rising interest rates could implode the housing market, take the wind out of the stock market, derail the modest economic recovery, and put a serious squeeze on the middle class, whose incomes have not been rising as fast as inflation and whose continued prosperity has been fueled in large part by massive increases in the value of their homes.
Right now, it’s unclear whether the employment and export benefits of Chinese devaluation will help the American economy more than the reduced level of Chinese asset flows will hurt. The only reason this is such an open question is because of government fiscal policy. If the US budget were still in surplus, or even within sight of being balanced, the importance of Chinese investment in American debt vehicles would be minimal. As it is, however, we’ve become dependent on the willingness of the Chinese central bank to purchase US debt at low interest rates. If that were to slow significantly, it would not only hurt the overall US economy, but explode the budget deficit because of the higher cost of debt service.
The recent move by the Chinese central bank was long anticipated and cost-factored in to the market, so it is unlikely that we will see any disruptive results in the short term. However, the move to decouple the Yuan from the dollar introduces long-term uncertainty. What should be totally welcome news from the perspective of US workers, consumers and exporters turns out to be cause for concern, given the calamitous state of the Federal budget. By massive, unfunded borrowing, American legislators have outsourced a critical factor in our prosperity to a foreign central bank whose leaders are unaccountable to, and unconcerned with, the financial security of US citizens.
11:43:26 AM 
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