Those of you too young to remember the Cold War may not appreciate the subtleties of the dance involving North and South Korea, China and the United States. It’s a form of communication where superpowers express their positions through the actions of surrogates rather than diplomatic channels. If this is a return to Cold War communication, it would indicate that China used its proxy, North Korea, to send a message of discontent to the United States when they fired an artillery barrage on Yeonpyeong Island.
China’s unhappiness is understandable. After enjoying near double-digit GDP growth every year since 1994, there are signs that the Obama administration is intent on leveling the playing field. With its citizens demanding an ever higher standard of living, a cooling of China’s red-hot economy could galvanize its labor movement and lead to major and sustained political strife. It’s important to understand the dynamics that’s led to the expansion of the Chinese economy in order to appreciate what’s at stake.
By keeping its currency, the yuan, artificially low, Chinese manufactured goods have dominated international markets the past two decades. Cheap Chinese labor has also enticed many American manufacturers to move operations there. During the George W. Bush era, the migration was incentivized by the Corporate Foreign Tax Credit given to corporations to move jobs overseas, particularly to China. However, as China’s economy expanded, so did the expectations of workers that they would reap a greater portion of the pie.
Foxconn, a Taiwanese company, was forced to increase wages by 30% to its factory workers in China in June, followed by another 70% a week later. Workers are still not satisfied, yet the labor cost-differential between manufacturing in China and the US is closing rapidly. Foxconn’s intent was to raise wages by far less for the entire year, so these are major concessions to labor.
Another blow to China and the companies that have shifted their manufacturing there could be the discontinuation of the Corporate Foreign Tax Credit. Even with the wage disparity, many companies couldn’t justify the expense of operating overseas without the tax credits. End the Corporate Foreign Tax Credit and the gap between manufacturing costs in the United States versus China reduces even more.
Then there is yuan, hugely undervalued until the last couple of months. Mirroring former presidents Franklin D. Roosevelt and Richard Nixon, it appears that Obama intends to devalue the dollar, which will be a devastating blow to China’s economy. Several nations have lamented China’s irresponsibility in artificially depressing its currency, and it appears the United States is about to enter the debate in a decisive fashion.
Being a net exporter of manufactured goods, China has relied on a weak currency to artificially depress the cost of its goods, but the rest of the world is saying enough. With low core inflation and interest rates in the US, devaluing the dollar is the smart move, one that’s already being pursued by the Fed.
China also holds upwards of $800 billion in U.S. Treasury bills, making it our largest creditor. Devaluing the currency will devalue those T-bills, further weakening China’s financial position. An indication that this strategy is being enacted is that banks are dumping dollars in favor of yuan. Increased demand for yuan coupled with banks dumping dollars will relatively strengthen the Chinese currency, making their manufactured goods less attractive in the United States and the rest of the world.
The extent of US banks holdings of yuan is not readily available, however with the currency having been undervalued for so long it’s hard to imagine banks having not hoarded them. American banks are in the business of buying low and selling high, which would make yuan an attractive acquisition, especially if they knew the American dollar was about to be devalued. Strictly conjecture on my part, however it felt like the banks rolled over far too easily on the Wall Street regulation bill, which would indicate a quid pro quo with Obama was in place. Three major banks, Citigroup Inc, HSBC Holdings Plc and CIMB Group Holdings Bhd, have announced their intentions to invest in yuan bonds. This news will drive the demand for the Chinese currency, further boosting its value against the dollar.
Assuming a quid pro quo relationship, this is exactly the way American banks would proceed to drive their position. It’s the same thing that happens every time Warren Buffet addresses the media with his opinion about a particular investment vehicle. A few words from Buffet can drive the value up or down in a matter of minutes. News that these three major banks are buying yuan-based investments will have the same effect. The promise of this kind of payday might be what enabled Obama to gain Wall Street’s acceptance of his financial regulation package. They can still make money, just not off the backs of working Americans, at least for now.
Obama also gets to feed Big Labor by making it more cost-effective to manufacture goods in the United States than in China. American corporations that held the line and kept jobs in the United States will benefit as well, not having to pay to relocate manufacturing capacity back to the United States or some other country. By embracing inflation he drives wages up, making people more able to afford that which they already own, and hopefully getting them above water in their homes. Obama wins all around on this one.
China is soon to experience some unpleasant fiscal consequences, mostly self-inflicted, albeit with help from Western banks, that will complicate the lives of its leaders. Mounting labor strife, decreased demand for its manufactured goods and an overheating economy that suddenly cools off is a trifecta no politician wants to face. Chinese leaders will reap the consequences of what they’ve sown for the last 20 years, and they don’t like it.
Although North Korean leader Kim Jong-Il is reputedly unbalanced, it’s difficult to imagine him doing anything other than accepting direction from his only benefactor, China. It’s implausible that the exchange of artillery fire with South Korea was other than at Beijing’s direction. Beijing was expressing to Obama, “With all your other problems, you could have a war in Korea as well.”
Obama has responded by sending the USS George Washington to the China Sea for joint maneuvers with the South Korean military. It seems his response to China, by way of North Korea, was, “Let’s see you do anything with an American aircraft carrier sticking out of your ass.”
With 1.3 billion people, China could support North Korea with troops for an extended period, however the strengthening yuan proves problematic. As yuan strengthens, so would the cost of any war in which China finds itself. Conversely with a weakening dollar, the cost to America gets cheaper. Plus, South Korea is the only hot spot in the world where America is bound by treaty to act, so all Obama would have to say to justify it to the American people is that America honors its commitments. If war to re-ignite the economy is the plan, Korea is the ticket.
They’ll be lots of doom and gloom rhetoric as the value of the dollar slides and inflation heats up, however it will bring jobs for a job starved economy. I think most people will tolerate inflation just as long as they have a job whose wages are keeping pace. When it’s all said and done, the biggest winners will be Western banks who profited off the currency flip.
China is about to find out what happens when you swim with the sharks, and it won’t be pretty. We are preparing to drop a financial nuclear weapon of mass distraction on them, and they won’t know what hit them. Be glad you don’t live in China right now.
Larry Wohlgemuth was raised during the tumultuous 60s in the midst of sometimes violent civil rights and antiwar protests. After a stint in the Air Force during the Vietnam War, he earned a BBA degree from Washburn University. Wohlgemuth leans so far to the left he prefers to be called “Comrade”, and his book, “Capitalism’s Final Solution” is planned to be released in the spring, 2011. Larry is a contributor to Prose Before Hos and runs his own blog, It Begs the Question.