Yuan Revaluation, Euro Weakness, and the U.S. Recovery

When it comes to the heavily-debated topic of yuan revaluation, I am in the camp that believes the yuan is undervalued overvalued and ought to be revalued. That said however, I have advocated caution with respect to how soon and how fast such an appreciation should take place. My main concern revolves not only around the impact of a yuan revaluation on the Chinese economy, but also its knock-on effects to the U.S. economy (see China and the Revaluation of the Yuan and Yuan Again).

In the former post I opined:

Think about the short-term shock to the Chinese economy, which depends upon exports for a good portion of its GDP. By many accounts, exports make up some 25% of Chinese GDP. A revaluation of the yuan makes Chinese exports relatively more expensive thereby decreasing foreign demand for Chinese-made goods. This negatively impacts local production and creates a feedback loop through to domestic employment and wages. In the extreme, this threatens social stability, and China is certainly not the poster-child for social stability.

Not only that, but given the foreign interests and investments in China, it is not entirely clear to me that a yuan revaluation that catapults China into recession would not result in a global contagion effect. Supply chains are so interconnected around the globe that an upward price movement for intermediate and finished goods coming out of China could have dire consequences for Western companies that rely on Chinese-sourced goods (just ask Wal*Mart).

In the latter post I added:

…the near term economic adjustments associated with a significant rise in the value of the yuan could be painful, not just for China, but for the rest of the world as well. In addition, a sudden rise of the Yuan could be socially destabilizing for China. Given China’s already tenuous political and social situation, it is therefore difficult from a policy standpoint for Chinese politicians to justify…

So basically, China has made a commitment to a production-based, export-oriented economy. Although it certainly is in the long-term interest of China to rely less on domestic investment and exports while encouraging domestic consumption, such an adjustment takes time and there are adjustment pains associated with such a shift. Similarly, any shift of the US economy from one that relies on consumption to one that is centered around production would likewise take time and require some painful adjustments.

I was therefore not surprised to see a recent article summarizing the stance of Justin Yifu Lin (chief economist of the World Bank) with regard to a yuan revaluation. He echoes the sentiment I expressed, and details the nature of some of those “painful” adjustments (see Revaluation Would Hurt U.S.).

The chief economist for the World Bank said on Saturday that if China were to revalue its currency it would actually hurt rather than help the U.S. economy.

He acknowledged that if China stopped selling renminbi and buying foreign currencies, the policy that critics say keeps the currency artificially undervalued, Chinese exports would become more expensive.

But he said because most of the products China exports to the United States are labor-intensive goods U.S. manufacturers stopped making years ago, the U.S. would only have two choices: buy the products from other countries or from the Chinese.

Either way, Lin said, the cost of those goods would rise for U.S. consumers and that would depress both consumer spending and job creation in the United States.

So again, although I agree that China needs to address the yuan-dollar peg, a gradual revaluation to competitive levels is probably the best outcome for the global economy. A sudden rise in the value of the yuan could come with painful near-term adjustments that derail the currently fragile global recovery.

But that said, there’s now an additional complicating factor: With the euro depreciating against both the dollar and the yuan, any plans that Chinese policymakers may have had to revalue the yuan against the dollar are likely to be put on hold (see Europe’s Debt Crisis Casts Shadow Over China).

The pain of the European debt crisis is spreading as the plummeting euro makes Chinese companies less competitive in Europe, their largest market, and complicates any move to break the Chinese currency’s peg to the dollar.

…in light of the euro’s nose dive, such a move could be difficult. Letting the renminbi rise against the dollar would also mean a further increase in the renminbi’s value against the euro, creating even more problems for Chinese exporters to Europe.

Some Chinese companies are already running into difficulty because of the euro’s fall against the renminbi.

“We have been receiving calls from some European clients who signed contracts with us earlier this month, and they all want to cancel their orders, since the depreciation of the euro has eroded all their margins and then some,” said Elvin Xu, the sales manager of Guangdong Ouyi Electrical Appliance in Zhongshan, China, which makes gas stoves, heaters and water heaters.

“They say they cannot increase the prices at their end to their customers, given intense competition in their marketplace,” Mr. Xu added.

In an example of just how interconnected the global economy has become, it is not just Chinese exporters that are adversely impacted by the weakness in the euro, but U.S. exporters as well.

Because American companies in particular compete in the Chinese market with European companies in many industries, the euro’s weakness against the renminbi is putting American companies at a disadvantage.

And the effects are not limited to China.

Euro weakness (dollar strength) lowers the overall profitability of American multinational corporations. It lowers profitability through the repatriation channel (each 1€ of profitability is now the equivalent of only $1.23 in profit). It also reduces the profitability of American exporters as U.S. exports become more expensive in European markets reducing demand for U.S. goods. And it makes it more difficult for American companies to compete with European companies not just in China, but in export markets worldwide as European products become relatively cheaper.

So the problems in Europe that some pundits believe are now largely contained can have serious consequences for global economic growth. And as the New York Times article rightly concludes:

…even China — the world’s fastest-growing major economy and increasingly the engine of global growth — is not immune to the crisis that started in Greece…

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