Renminbi Appreciation: What it means to US Consumer Inflation Index

Repost: 1/21/11

New reality slowly setting in

It is no surprise that China’s political and economic power has increased dramatically over the last decade. But what is surprising is the lack of recognition from governments and citizens of the western world that China wields substantial power during current negotiations.

This new reality can be seen from the United States Congress and the White House’s often ignored, yet continued pressure for the faster appreciation of the Renminbi, China’s official currency. The major reason for China’s delay is because many developing nations do not agree with the United States’ low interest policy. Keeping interest rates at 0.25% has caused investors looking for higher returns to look to developing nations for investment and such huge inflows of capital are causing rampant inflationary pressures.

Needless to say, America is not easily getting what it wants since, more often than not, creditors, not debtors, set the terms of financial arrangements. Therefore, America’s attitude towards China (at least publicly) has a long way to go to catch up with the new economic reality.

Largest foreign creditor: China

To save the American economy from the brink in 2008, the country’s government had to take unprecedented action that resulted in a five trillion dollar explosion of public debt. China’s U.S. Treasury holdings have almost doubled to $750 billion since that year, surpassing Japan as the largest holder of U.S. debt.

In December, the Federal Reserve passed China as the largest holder of U.S. treasuries as its balance sheet increased from an approximated $800 billion in the middle of 2008 to over $2 trillion by the start of 2009. With America not addressing its growing public debt, China has expressed the need to diversify their foreign investments in assets denominated in currencies other than the USD.

Eurozone support

As one of the major creditors of the world, China has been providing support to another important trade partner, the Eurozone. This initiative has helped diversify Chinese foreign reserves through the purchase of sovereign bonds from countries such as Greece, Portugal, and Spain. Portugal and Spain had bond auctions on January 12th and 13th which went better than expected based on continued Chinese commitments to help stabilize the region.

Prior to the auctions, Japan also pledged to support the Eurozone by purchasing European Central Bank notes that will raise capital for the European Union’s financial-aid fund.

What happens if the Renminbi is adjusted?

Is the Renminbi undervalued? If so, by how much? Is China manipulating the Renminbi? Is the Fed manipulating the USD through quantitative easing measures? Who is right and who is wrong?  It is not the intent of this piece to answer these questions but to look at a potential Renminbi adjustment scenario.

Suppose, as per Timothy Geithner’s assertions, that the Renminbi is “Significantly undervalued”. What are the implications of an adjustment? From an American perspective, an adjustment will make Chinese exports more expensive on the world markets, thereby increasing the competitiveness of the domestic export sector. This would in turn increase employment in the United States, which has scarcely recovered since the 2008 downturn.

The linkage between an undervalued Renminbi and the American unemployment rate has been exploited by government officials and media and has ultimately led to an increase in anti-China sentiment. Still, there is little discussion surrounding the ramifications of an appreciated Renminbi – remember that in economics there is always a trade off.

What manufacturing base?

The U.S. employment in the manufacturing sector is at levels not seen since the 1950s. Many multinational companies have left the United States in search of lower manufacturing costs in the developing world. More specifically, since 2000 nearly five million jobs have been lost in this sector. How long will it take the U.S. economy to recapture manufacturing investment and train new workers? The expectation of a quick and dramatic increase in employment after lifting the Renminbi peg has been greatly overstated. This is not to say that an increase in jobs will not occur, but it will take years for investment in factories to translate into sustainable job growth.

No such thing as a free lunch

The less desired implication of a revaluation is simply inflation. Basing this analysis on the assumption of a 10% undervalued Renminbi, the purchasing power of the U.S. with respect to China will decrease by 10%. Consider Wal-Mart, the world’s largest retailer, as an example. The company imports the majority of its goods from China, which in turn allows Americans to purchase inexpensive goods as a direct result of the undervalued Renminbi.

A 10% increase in prices at local Wal-Mart stores will adversely affect the already-struggling low and middle class. Considering that over 14% of all Americans are currently enrolled in the food stamp issuing Supplemental Nutrition Assistance Program, such inflationary pressure will have dire consequences for the majority of the population. This pressure will also be felt in Canada as price increases will occur for all imported Chinese products. It should be now clear why this side of the story receives so little attention, as it would result in awareness of the true cost of a Renminbi re-evaluation.