By John L. Chapman, Ph.D.                                                                                                                                             Washington, D.C.                                                                                                                                                                      November 13, 2011

Mitt Romney may well be President Obama’s opponent in the 2012 elections next year, but there is one thing on which there is no daylight between them: both agree that the People’s Republic of China is a rogue state when it comes to management of the yuan (CYN) exchange rate.  President Obama has recently stated he is concerned about China’s currency policy and will bring it up in meetings with China’s President Hu this week: “…we need to make sure our goods are not artificially inflated in price and their goods are not artificially deflated in price; that puts us at a huge competitive disadvantage….[vis-a-vis China].”  Mr. Romney scoffs at this: he says Mr. Obama has been rolled by the Chinese, and the former Massachusetts Governor promises a much tougher stance against both currency manipulation, high-tech espionage, and intellectual property theft.

Trade with China has long been a contentious issue.  During the calendar year 2011, U.S. firms will sell about $80 billion worth of goods and services into China, up 20% from last year.  And, in turn, American businesses will buy nearly $300 billion in goods, mainly manufactured,  from China (up about 11% from 2010).  The resultant $200+ billion bilateral deficit with China will total nearly 2/5ths of America’s global merchandise trade deficit, long a sore point for political interests who decry “lost jobs” to China, and lowered profits for American manufacturers.  And in an election year, such an issue only heats up more than usual.  Said Mr. Romney recently:

I’m afraid that people who’ve looked at this in the past have been played like a fiddle by the Chinese.  And the Chinese are smiling all the way to the bank, taking our currency and taking our jobs and taking a lot of our future.  And I’m not willing to let that happen…… I will sign an executive order on my first day in office identifying China as a currency manipulator, [and we will go] to the World Trade Organization with it. …… [Current policy vis-a-vis China] is a trade surrender, let me call it that….It’s just crazy for us to be fearful that somehow if we crack down on cheaters that that’s going to be a problem…..

I am an enormous advocate for free trade, but if someone cheats on the agreements and they block the ability of our goods to be sold in their country and they empty out our businesses by virtue of cheating, that you can’t allow to go on. That is not free trade.

Making matters more intense, many Democrats on Capitol Hill seek to get tougher with China as well in time for the coming election year.  Last month the Democrat-controlled Senate passed a bellicose trade bill on China by 63-35; the legislation calls for immediate revaluation of the yuan or risk steeper tariffs on Chinese imports.  Protectionism is, alas, alive and well on Capitol Hill, and is still as bipartisan as it was in the 1930s.  What is the right way to think about this?

First, it is important to put the magnitude of exchange rate changes into perspective.  The chart below shows the yuan/dollar exchange rate for the last 30 years up to today’s 6.34 CYN/$1 USD.  China opened trade with the U.S. substantially after Deng Xiaoping’ market reforms beginning in 1978, when it began a conscious policy of acquiring foreign reserves (though bilateral trade really took off beginning in the 1990s); the initial exchange rate then was 2.78 CYN/$1 USD, and this climbed to 8.7 yuan through deliberate policy on both sides by early 1994.  After being revalued slightly to 8.3 by 1997, the Bank of China then announced a conscious policy of maintaining stability around 8.28 CYN amidst the Asian financial crisis and competitive devaluations throughout the region.

This was maintained until 2005, when China reverted to its 1994 policy of a “managed floating” rate regime, allowing the yuan to move in an orderly way according to market forces. Since then, as shown, the dollar has depreciated some 22% against the yuan:

Chart I. Chinese Yuan (CYN)/U.S. Dollar Exchange Rate, 1981-Present

Looking at this from China’s perspective, the stable currency coupled with World Trade Organization (WTO) membership after 2001 has led to strong GDP growth, albeit concentrated in the coastal regions, in the last 15 years.  The stable currency (and guarantees on profit repatriation) led to a quadrupling of fixed capital investment in the ten years after mid-1994, and another doubling in the four years after that, as shown in the following chart:

  Chart II. Gross Fixed Capital Investment (in Constant CYN [Yuan]), 1970-2008

This year total fixed investment will be more than $2 trillion in China for the 4th year in a row; so much so now that talk is rampant of a bubble in commercial real estate and excess infrastructure that has outpaced real demand.  And what of the trade deficit?

It is true that the Chinese government has systematically maintained an explicit value for the yuan for much of the past thirty years.  But for many of those years its stated strategy has been to peg the yuan to the dollar, and passively “outsource” its currency policy to the U.S. Federal Reserve and Treasury.  This is the point that Messrs. Obama and Romney both seem to forget: had the value of the dollar not depreciated on global markets, pressure on the Chinese to revalue the yuan would be a moot point.  That is to say, it is the U.S. government and its central bank that have been guilty of currency manipulation, if anyone has in this bilateral relationship.

Having said this, it is clear that Chinese consumers, and likely some producers, have paid a price for the policy of currency stability (instead of secular appreciation) vis-a-vis the dollar, as it has been pursued by the Chinese government.  Without question the fix to the dollar has helped promote foreign direct investment  (up 11% this year to surpass $200 billion) which, coupled with government-directed funding of infrastructure, has totaled more than $10 trillion in the last six years.  This has helped impel China’s GDP to double digit annual growth rates for the better part of 20 years.  GDP in China in 2011 is now estimated to be headed toward roughly $6.7 trillion, or a little less than half that of the United States, good enough though to make China the second biggest economy in the world now (although with GDP per capita in the $4,600 range, it is still a very poor country).

But this growth in production has not translated out widely into increased living standards for Chinese consumers across the vast interior of the country.  One benefit of a stronger yuan will be more consumer goods available for Chinese workers, who have also been burdened by continuing low-grade inflation for all the years of the peg (or dirty peg) to the dollar; back up to over 6% recently after doubling in the last year, it is moderating now.  But this is one negative consequence of resisting a freely-floating currency that would trend higher against the dollar absent the peg: higher domestic inflation.  China’s food prices were up over 11% in the last year and there were rumors of riots in the interior.

Nor has the peg and artificially undervalued yuan necessarily helped all producers.  First, by definition, at best it will only help exporters, at the expense of domestic producers who face continually rising prices.  And even among exporters, the artificially depressed-in-value yuan will only benefit them if their volume in sales is greater than their loss in margin due to the weaker-than-market-dictated renminbi.   That is to say, if the yuan-dollar exchange rate is 6 CYN/$1 USD when it “should be” 4 CYN at “true” market exchange rates (keep in mind it is impossible to know exactly what the free-floating CYN/$ exchange rate would be), the Chinese exporter is losing 33% of real value vis-a-vis American importer-consumers versus what the exporter would obtain without the dollar peg.  He therefore has to sell 34% more in total volume to begin to gain from the depreciated currency that stoke his exports.  Who gains or loses under this arrangement is a matter of empirical investigation with respect to demand elasticities, but there are countervailing cross-currents.

“Currency manipulation” is thus in the eye of the beholder, but in any case, it always involves winners and losers in each affected country.  In this case, China made the conscious decision in 1994 to stabilize the yuan and peg it to the dollar to solidify investment, and among other things, given a profligate Federal Reserve, it was tantamount to the Chinese subsidizing American importers (and consumers) for many years.  As a general matter, in prior eras China would have been commended for a fixed exchange rate that sought stability with the United States — purveyor of the world’s de facto reserve currency.  But in the hyper-politicized world we live in now, the Fed seeks to debauch the value of the U.S. currency, and America’s political class expects China to ratify their systematic, multi-year-long stupidity.  And this of course does not even take into account the fact that Chinese appreciation for the yuan will hurt the value of China’s considerable dollar-denominated asset portfolio.  Do Mitt Romney and Barack Obama expect China to willingly absorb self-inflicted self-wounds merely to make Ben Bernanke look better?

The first-best solution, of course, is a dollar with a fixed value to an external benchmark that cannot be politically manipulated, such as gold.  If China then matched this, and let the terms of trade fall where they may based on the law of comparative advantage, global wealth would be multilaterally optimized.  As the experience of Japan showed between 1960 and the mid 1990s, when the yen/dollar exchange rate fell from 360 to 83, a country can become an “export machine” even in the case of a persistently stronger currency; this is so because import/export decisions are made according to many parameters in addition to currency exchange rates.  At the very least, until we one day again achieve a modicum of monetary stability, perhaps Messrs. Obama and Romney should beware of throwing stones from Ben Bernanke’s glass house.

For information on Alhambra Investment Partners’ money management services and global portfolio approach to capital preservation, John Chapman can be reached at

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