America’s Obsession with Exchange Rates – Seeing the Trees, Ignoring the Wood

April 09, 2010

A good friend, weary of my persistent pessimism about the state of the global economy, insisted last week that we should all now be at least “cautiously optimistic” about the prospects for recovery. No, I said – everyone is “prematurely cautiously optimistic”.

This is all very perplexing. I see myself as a happy, positive, optimistic person. Even some of my friends accept this to be so. Why am I so weighed down by the forebodings ahead, when so many others are full of talk of “green shoots”, a consumer rebound, and resurgent exports?

I’m sure much of the self-deceptive optimism comes from the stimulus package “methodone” that has been fed to the heroin-addicted global economy since 2008. With governments keeping banks flush with money, keeping interest rates at record low levels, it is perhaps not surprising that banks have been able to “lend and pretend” – pretend that mortgage loans will be repaid, pretend that credit card debts will be repaid, pretend that house prices will recover to a point where big write-offs will not be necessary, pretend that core capital requirements will not in due course be raised, forcing a sharp contraction in lending activity.

But the warnings are becoming clearer that the stimulus “methodone” needs to be turned off soon. Government debt levels in the US, the UK and Europe are at unprecedentedly high levels, leaving governments with no wiggle room to provide more stimulus. As David Roche of Independent Strategy noted last week, average sovereign debt levels among OECD economies have leapt from 44% to 71% of GDP since 2006, requiring fiscal tightening of between 8-10% for each of the next five years for debts to be brought back to 2007 levels. UK and US government debt has jumped past 100%, of GDP and Japan’s sits above 250%. At these levels, sovereign defaults more juddering than those of Greece or Iceland may be in store.

As governments begin to address their daunting debt problems, taxes must rise and government-funded services (no doubt including health care, education, for example) must fall. This will keep unemployment high just as governments pray for unemployment to fall. And whatever the recent positive export signals from Asia, these factors together suggest that the US and European consumer are unlikely to be in any condition to lift consumer spending in the foreseeable future.

It is this prospect of impending cold turkey that has no doubt led leaderships in virtually every indebted developed economy to say they plan to boost exports to help them lift their economies our of the quagmire. But if everyone plans to export, without at the same time lifting their imports, then we face a very simple and irresolvable conundrum: where on earth do these exports go.

It is this panic reluctance to stare the massive domestic challenges in the face that has led to a wholly irrational – but politically expedient – convergence on exports as a panacea. And the next equally irrational – but politically expedient – step is to decide China can become our importer of last resort – if only its “fixed” currency can be unfixed. I can understand economically illiterate politicians being seduced by this “logic”, but it is embarrassing and disgraceful to see so many supposedly reputable economists mouth the same message.

So let’s be clear on two things: first, it is an unhappy reality that the only likely source of new import demand for the foreseeable future is in the developing world, and in particular in China. Recession-harried economies around the world are not wrong to place their hopes on China to provide some stimulus. But China’s domestic consumer economy is small – barely 16% of the US’s consumer economy – and the capacity to raise consumption speedily is extremely limited. With most of the country’s rural economy outside any definable consumer market (380,000 Chinese villages don’t have even a single small village store), average annual incomes on the wrong side of US$4,000 a year, and an absence of government-funded safety nets for education, health care, or old age provision, consumer demand in China’s domestic market can grow only slowly.

Second, messing around with China’s exchange rate will do nothing to dig Americans out of the hole they have dug for themselves over the past decade. Remember Japan in the 1980s: under ruthless duress from the US government, Japan doubled the value of the Yen against the dollar, without any perceptible impact either on Japan’s exports, or on Japanese demand for US exports. There are many reasons why China’s trade performance will be wholly unaffected by a revaluation of the RMB, including:

  • barely 20% of the value of most Chinese exports is attributable to costs incurred inside China. Most of the cost of an iPhone, for example, is incurred either before the components or subassemblies reach China from other countries in Asia, or after it has left China in the form of wholesale and retail profit margins. And all of these costs are US$ costs. If the RMB were to be revalued, even by 20%, this would affect only the 20% of the cost incurred inside China.
  • Even if revaluation lifted the cost of an export item from China, no country in Asia (except in due course India) has the potential to fill China’s shoes. Vietnam, for example, has an economy 100th the size of China, and could not possibly absorb even a tiny fraction of the tens of thousands of export-oriented factories that have made the Mainland their home. And is anyone seriously suggesting that an American worker would be willing to work in a factory trying to relocate the manufacture of garments, shoes and consumer electronic items back the US – when Chinese manufacturing salaries currently average about one tenth of US manufacturing wages?

China’s leaders recognize that in due course their currency is likely to strengthen. Indeed, comments from Beijing officials early this week suggest that new policies are imminent that will allow the currency to appreciate. They recognize the need to rebalance their economy, gradually to build domestic consumer demand and reduce reliance on exports. For anyone who cares to look at the data, the Chinese are already taking action on this front – domestic demand has risen by close to 10% a year for the past two years, and the country’s once-burgeoning trade surpluses are dwindling. Hong Kong factories that until last year were allowed only to export are now being allowed to sell their goods into the domestic economy.

But as they wrestle with their own formidable challenges in managing economic growth in their own large economy, they are not going to allow economically illiterate US politicians to force their hand. Instead, they seem inclined to do exactly what US leaders should themselves be doing: making sure they put their own economic house in order, despite the dreadful economic setback inflicted on the world economy two years ago largely as a result of excesses nurtured recklessly in the US.


* The translated Chinese version was published in Ming Pao on April 9, 2010.

[ Back ]