what China is doing

Over the weekend, the People’s Bank of China announced that it was changing its policy of closely managing its currency to mimic the movements of the US$.

From now on the renminbi will be linked instead to a basket of currencies representing China’s major trading partners, the largest of whom is the European Union at 16.3% of total trade (the US follows with 12.9%, ASEAN with 10.4%, Japan with 9.4% and Hong Kong with 7.5%).  There’s nothing unusual about this change.  It’s what emerging economies with global trade typically do.

China won’t have a free float, however.  Allowable daily currency fluctuations will be limited and the central bank will manage the float by setting the midpoint of the daily trading band.

no dramatic short-term movements

Economists are speculating that the renminbi will appreciate vs. the US$ by one or two percentage points in the coming year.  The People’s Bank is making it clear it doesn’t intend to do more.  And, given that the euro has fallen by about 20% against the euro over the past six months, if China were following its basket rule, it would be depreciating its currency by about 3% against the basket.

market gains today

Nevertheless, China allowed the renminbi to appreciate by .42% against the US$ today, its largest gain in five years.  World stock markets have responded enthusiastically, both to the Chinese announcement and the market action of the currency.

implications for China

As I’ve written extensively in this blog, the standard strategy for developing economies to achieve technology transfer from the developed world is to offer cheap labor.  Japan is the poster child in Asia of this strategy.  The developing country will make sure it retains its labor cost advantage by pegging its currency to that of its target trading partner, usually the US.

In theory, as time passes the developing country begins to allow its currency to appreciate as a way of steering its industry toward higher value-added activity.  This process should at the very least begin before the country runs out of labor and triggers an inflationary wage spiral.  In practice, the newly prosperous labor-intensive industries have enough political clout to preserve the status quo, and their profits, despite the fact that this begins to do long-term economic damage.

One sign that a country is near the point of exhausting the available labor force for a given level of technology–and that currency appreciation is the appropriate response–is when strikes, or other forms of labor dispute, arise and large wage increases result from them.  This appears to be happening in many places in China today.  A political struggle also appears to be occurring between economic planners, who favor a stronger currency, and forces of the status quo, who want to preserve their current position.

The strong financial market response to China’s (so far) modest currency move seems to me to be a sign of relief that events appear to be moving in the right direction.

implications for the US

In one way of looking at things, if a developing country decides to make a continuing massive subsidy to its trading partners by undervaluing the labor content of the goods it sells, the recipients should say a silent “thank you” and keep on accepting the gift.  But doing so on a large enough scale may end up distorting the recipients’ economies.  Put aside (for a later post) the long-term effects of this and for now look at the short term and at the US.

The political drama surrounding trade with China became ritualized in the US during the frequent Congressional hearings on renewing that country’s most favored nation trade status.  Congress would posture for a domestic audience by threatening trade sanctions.  One house or the other would sometimes introduce protectionist legislation, confident that the president would veto it if the bills got that far.

This time around, Senator Charles Schumer of  New York, noted more for his fund-raising from Wall Street than his knowledge of economic history, has introduced a twenty-first century version of the Smoot Hawley tariff law (the one that caused the Great Depression of the 1930s).  Observers have feared that neither Mr. Schumer nor Mr. Obama knows his role in the drama–that Mr. Schumer will push too hard for his bill’s passage and that a weak president will sign it into law.

A second reason for rising stock markets today is the thought that this outcome is now less likely.

implications for stocks

The standard rules apply:  having revenues in an appreciating currency and costs in weaker currencies is the best position to be in.

One other thought–workers who get large raises and who also receive them in an appreciating currency have a lot more purchasing power.  So sellers of euro- or dollar-cost merchandise in China should do relatively well.  Outbound tourism from china should also boom.  The first stop is likely Macau and Hong Kong.  Next comes Japan, then the EU.  As Marriott has recently pointed out, the US may not be a big beneficiary, however.  The government’s anti-terrorism concerns have made it difficult for ordinary Chinese citizens to get a visa to visit.