Jack Austin Centre analysis: The US/China Currency Dispute, and its Impact on Canada

by Ed Bukszar, Ph.D., Simon Fraser University – for the Jack Austin Centre for Asia Pacific Business Studies, Beedie School of Business

On October 11, the United States Senate passed a bill, by nearly a 2 to 1 margin, calling for the imposition of tariffs on Chinese imports. Tariffs are necessary, according to the Senate, because China is manipulating its currency, keeping it artificially undervalued. Senators claim that undervalued currency siphons jobs from America by keeping Chinese labour costs artificially low. With unemployment hovering near 9% in the US, and a presidential election due in about a year, we should expect this issue to be front and center for the foreseeable future.

The Senate bill strikes a populist chord in America, but is unlikely to be implemented. House Speaker Boehner has indicated that he may not allow a House vote on the tariff bill; he sees it as overstepping the role of congress. The Senate bill pressures China, but perhaps equally important, forces the Republican-controlled House of Representatives to take a politically unpopular position as an election approaches.

The Chinese do not vote in American elections, making them easy targets. The outsourcing of manufacturing jobs from the US to lower-skilled and lower-cost regions of the world has been ongoing for decades, and is supported by strong strategic rationale at the corporate level, and free-market policy at the national level. Yet the sheer volume of Chinese imports is hard to ignore, especially in a weak economy. Chinese GDP growth rates are still robust at approximately 9%, and the Chinese economy is largely fueled by exports to the developed economies in North America, Europe and Japan. China has grown by virtue of its low-cost advantage, and an undervalued currency contributes to lower costs in China.

Responding to worldwide pressures to float the Yuan, the Chinese government has allowed some movement in their currency; the Yuan has appreciated against the US dollar by 25% over the past six years. But China tightly controls its currency, and it sets the value of the Yuan to match its own economic priorities – key amongst those – to maintain high employment rates by promoting exports. The Chinese government sees its survival tied closely to the economic improvement of its citizens, relieving internal pressure to increase personal liberties.

Complicating matters, trade imbalances between the United States and China, partially the result of currency inequities, have created vast US dollar holdings in China. US budget deficits, enormous since the recent recession, pull these US dollar holdings back into the US in the form of investments in Treasury Bills. The Chinese government is the single largest investor in US Treasuries. A common perception in China is that their hard work and savings are supporting American excesses and America’s failure to live within its means. And Americans feel increasingly dependent on the continued investments that China makes.

Few things rankle Americans more than the sense of dependence on other nations. Dependence creates power in inverse measures. The Chinese government exacerbates this unease by voicing its unhappiness with the central role of the US dollar in the world’s economy. Its vast US dollar holdings – approximately $1.5 trillion – are affected by US monetary policy. As the world’s reserve currency, the US can fund deficits by easing its monetary policies, as the Federal Reserve did in its QEI and QEII efforts to refloat the American economy. A cheaper US dollar means Chinese dollar holdings become less valuable.

The Chinese government has indicated that it expects the Yuan to become a reserve currency in the not-too-distant future, and that such a move would be beneficial in that it would reduce the vulnerability of the global economy to the US. China is the second largest economy in the world and there is a sense of inevitability to its increasing economic power. China would like to expand its role in financial markets, building off its economic strengths.

However, while China is undoubtedly a major economic force, it is not positioned to take on a major role in the financial markets in the foreseeable future. To be a reserve currency, China would need to open its economy to world markets. China is anything but open, lacking transparency in its financial dealings. It lacks vibrant domestic markets; stable, predictable and transparent legal institutions; and the free-flow of information necessary to support either. It is a far more closed than open economy and it is hard to imagine the Chinese government easing controls to empower such institutions. Openness directly threatens the government, and runs counter to its long-held instincts. And while the leadership in China is about to change, and change is undoubtedly expected to occur over time in China, it would be a stretch to imagine this change as anything more than modestly incremental.

And so we can expect that the role of the US dollar as reserve currency will continue. Recently, in spite of a weak economy, the US dollar has actually appreciated against most major currencies around the world. With the financial crisis in the European Union and increasing concerns regarding a double-dip recession, the dollar has even appreciated by 7% against the Singapore dollar and 10% against the Korean Won in just the past month. Both are major trading nations, and as such are likely to quickly feel the effects of another global slowdown.

With indications of another global economic slowdown on the horizon, the Chinese government is unlikely to allow any significant appreciation of the Yuan at this time. Which leads us back to the status quo and the current impasse: continued trade imbalances between the US and China, with dollar holdings accumulating in China and continued Chinese funding of American debt. And Americans bristling at an undervalued Yuan.

It is, however, useful at this point to view these issues in the broader strategic relationship between the US and China. It is a complicated relationship with a tit-for-tat overtone. Cooperation between the two nations can be seen on numerous fronts while at the same time each presses for advantages in areas of interest. And those areas of interest are numerous. To name a few, the US would like China’s cooperation on fighting terrorism, constraining nuclear proliferation in Iran and North Korea, continuously presses China on human rights issues and worries about Chinese military expansion; while the Chinese bristle at US interference in what it sees as its domestic issues, US military support for Taiwan, and the expansion of free-market economies on its borders – including the possibility of Korean unification.

At times, there is great subtlety in the cooperation between these two nations on these issues. For example, last month the Obama Administration announced that it would upgrade the capabilities of existing Taiwanese F-16 fighters. Many saw this as a move likely to provoke a strong Chinese response. However, when viewed in context to the alternatives – selling newer and more advanced F-16s and F-22 Stealth Fighters to Taiwan – the upgrade can be viewed as a “standing down” of sorts. Perhaps it is not a coincidence that the Obama Administration has stood by while the Senate passed the bill related to China’s currency. The hoped-for tit-for-tat response from China may be continued appreciation of the Yuan, albeit with a face-saving delay. While this example may oversimplify, the key point is that the US / China relationship is complicated, and that analyzing the currency situation in isolation from other strategic concerns oversimplifies as well.

With respect to the value of the Yuan over the longer term, China’s dependence on export growth will eventually give way to a more robust consumer economy, enabling a more domestic focus for China’s economic expansion. But this is expected to be a gradual development, hindered by the lack of a social safety net in a culture with an aging population; savings rates must continue to be high. Yet even without further appreciation of the Yuan, labour costs in China are rising, undermining the country’s low-cost advantage. This is partially the result of inflation in China, but more so the result of greater demand for higher-skilled workers as the Chinese economy evolves from one based strictly on low factor costs, to one that produces value-added products.

In the long term, this evolution is far more threatening to US firms. Overwhelmingly, US firms compete internationally by producing value-added products and services, not by being low-cost producers. China’s low-cost advantages have served as a complement to US firms, enabling them to reduce production costs on the labour-intensive elements in their value chains. Presently, China has relatively few domestic companies, other than state-owned enterprises that compete with foreign multinationals.

The lack of a robust sector of private firms in China will slow the movement into value added production. However, the Chinese government has restricted access to its markets to multinational firms unless they have been willing to share technological knowhow with domestic firms. They do this by requiring multinational firms to enter the Chinese markets with domestic, joint-venture partners. An appreciating Yuan would put pressure on China to move to more value-added production sooner rather than later and would lead to more direct competition between US and Chinese firms – a capability made possible by the knowledge that Chinese firms have gleaned from joint ventures with multinational partners. The US should be careful what it wishes for.

The Impact on Canada: The Canadian Loonie is likely to maintain its high value against both the US dollar and Chinese Yuan into the foreseeable future. Continued weakness is expected in the US economy, and easy monetary policy promoting growth is also likely to continue, weakening the dollar. And with China reluctant to allow any change other than gradual appreciation of the Yuan’s peg to the US dollar, the Loonie will show continued strength against it as well.

For Canadians, this is a double-edged sword. A strong Loonie means a higher standard of living for Canadian consumers but for Canadian businesses it means tougher competition in world markets. To thrive in this environment, Canadian firms will need to rely on greater product and service differentiation to command price premiums or greater efficiency to compete on costs; both approaches would benefit from an increased focus on innovation.

The Canadian government could support innovation by advancing public policies that keep interest rates low to facilitate the long-term payback from R&D, and that encourage domestic firms to enhance their long-term viability through investments in value-added activities, enabling Canadian innovators to thrive in spite of their strong currency.