The taming of the dragon


March 08, 2011

Two days ago, the Chinese government revealed that in March their nation had a US$7.2bn trade deficit. 

This is the first monthly trade deficit since April 2004. Whilst the news is surprising to the general reader, it did not come as a complete shock to trade economists.
In recent columns, I have discussed the role of China in the global economy, with some focus on the effects on the undervalued Chinese currency. Ever since China pegged the yuan to the US dollar in July 2008, at a rate of 6.82 per dollar, it has had to bear the brunt of global criticism and anger.
Everyone from President Obama to EU heads of state to Indian ministers to union leaders across the world has castigated China for its currency policy. 
In the global economic turmoil that has followed the sub-prime mortgage and financial crisis, China has been held up as the chief culprit responsible for global trade imbalances and job losses in the developed nations.
It has become fashionable to bash the dragon over the head and insist that it must immediately either appreciate the yuan or free it and let market forces dictate its true value. 
A rebalancing of the global economy has become the mantra for Obama and his team, and this, according to them, can only happen if China increases the value of its currency and focuses on domestic demand-led growth instead of export-oriented growth.
This would lead to countries such as the US increasing sales of its products in China and the reduction of its huge trade deficits.
The taming of the Chinese dragon has become the most watched act in the global financial circus, relegating the act of making banking executives jump through hoops of fire to the number two slot.
The pressure from various constituents in the US has become so immense that Congress demanded a report from the Treasury on Chinese currency policy, and it was widely expected that the report would brand China a ‘currency manipulator.’
This report is due to be presented to Congress on April 15, but Treasury Secretary Tim Geithner has decided to delay its release until after a series of forthcoming meetings between China and the US, including a G20 Summit. 
Formally branding China a currency manipulator would unleash a chain of technical events that would severely undermine any chance of subtly taming the dragon. Geithner’s action indicates that it is almost certain that China and the US have already reached some compromise behind the circus curtain.
The news of the March trade deficit will have probably strengthened the position of senior Chinese government bureaucrats, who have so far resisted the whip of the American and other circus masters.
These bureaucrats will argue the March data shows that a rebalancing is already occurring, and that Chinese domestic demand has driven the surge in imports.  This domestic demand, coupled with ongoing weakness in its key export markets, will automatically lead to the desired rebalancing. 
This, however, would be wishful thinking.  The March data shows that imports increased by 66 per cent versus March 2009 to US$119.3bn and exports increased by 24 per cent to US$112.1bn.  
Within this macro data there remain a number of issues. China ran deficits primarily against Taiwan, Japan and South Korea, while it continued to generate surpluses with the US and the EU, who have been the chief circus ringleaders.
Increases in the prices of raw materials, including oil and iron ore, resulted in a 17 per cent increase in imports. Imports of crude oil in March were the second highest ever recorded.
Exports were capped, by Chinese admissions, because of a seasonal shortage of labourers as some migrant workers did not return to work immediately after the Chinese New Year holidays. All of this suggests that the March deficit is an aberration that is not here to stay.
The problems with global imbalances and Chinese competitiveness lie far deeper than the undervalued yuan. As I pointed out in my previous column, Indian manufacturing suffers from a 26-40 per cent higher cost than that in China, and the undervalued yuan results in only a portion of this superior Chinese competitiveness. 
The deeper issues revolve around very low unit labour costs and an artificially low cost of capital for companies, driven in part by an expansionary monetary policy.
With tens of millions of migrant labourers from the poorer hinterland earning less than the equivalent wage in India and powering coastal factories, and these factories borrowing money at half the rate of their Indian counterparts, it is no surprise that Chinese power generating and telecoms equipment is flooding in to India.
If India is struggling against the might of Chinese manufacturing, few other nations stand a chance.  
It is because of these far deeper and more complex issues with regards to China’s competitiveness that the easier-to-solve issue of the yuan’s strength will be tackled first. In spite of the March trade data, the yuan will almost certainly strengthen in the near future.  
To what degree is anyone’s guess, and is probably one of the most closely guarded secrets in Beijing.  
What does this mean for companies engaged in business with China, and how should they react? 
Any company that regularly imports products from China can go down one of two routes: either switch its purchases to other countries as the Chinese products become more expensive or hedge against the rising yuan. 
The only hedging possibility is to purchase Non-deliverable Yuan Forwards, which one can do up to 12 months forward.  12-month forward contracts are already trading at about 6.63 yuan per dollar, reflecting the expectation that the yuan will rise by about three per cent in the coming year.
The possibility that the yuan will rise more than three per cent is certainly a very real one. The taming of the Chinese dragon is of immense importance to the global economy. Letting the dragon continue rampage the global trading system is simply not an option for the rest of the world, and, in the long run, for the dragon itself.