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Implications of a Stronger Yuan
By: Dr. Charles Lieberman, Chief Investment Officer
Date: 6/20/2010
China began the process of allowing the yuan to appreciate, triggering a sharp rise in stock prices overnight. As always, China is acting in its own perceived best interests. It will now very gradually shift its growth model from being export driven to become more balanced between domestic and foreign demand. In time, its trade surplus should decline, while its living standards should continue to rise at a rapid clip. For us, the appreciating yuan will enhance domestic competitiveness and provide an incremental boost to our manufacturing sector.
Unofficial U.S. government policy for some time now has been to encourage the Chinese to allow their currency to appreciate. Finally, China agrees. Chinas strategy had been to use a cheap currency and low labor costs to grow exports, enabling the country to industrialize and improve living standards. This strategy is time tested, with the Japanese being the first to initiate it after World War Two and several Asian countries, Hong Kong, Taiwan, South Korea, Indonesia and Malaysia following their example. In China, this also created somewhat unbalanced growth, with the coastal cities benefitting, while its interior cities lagged. Still, it was a very effective way for the Chinese to promote economic development.
One adverse consequence of the Chinese strategy running such large surpluses also meant they accumulated vast dollar reserves, much of which was invested in Treasury debt. Fear mongers suggested that our bond market would suffer badly if they ever decided to invest elsewhere. In fact, the Chinese tried to go elsewhere. They bought some euro denominated debt. That didnt work out particularly well. They bought stockpiles of commodities. But, commodities dont pay interest and those markets are small. Finally, they came to the realization that our suggestion, allowing their currency to appreciate, was the right way to go.
The rise in the value of the yuan is likely to be very gradual, since China does not wish to disrupt trade flows. That would be harmful to their exporters, as well as to foreign countries. Over time, the U.S. trade balance with China should improve, particularly for commodities, like steel, corn and wheat, but also for more high value products, like aircraft. China will also buy fewer bonds, but fewer should be sold, as the domestic recovery reduces our budget deficit. Import prices will be a bit higher, so we must remain vigilant regarding inflation. As these various imbalances gradually decline, the risk of another crisis will be reduced.
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