In the twenty first century after the War on Islam dubbed as war on terror, probably one of the most debated issues in the international arena is the Chinese currency being undervalued. It is something that has received huge criticism from the western world especially from USA. For last few years USA has repeatedly called China to devalue its currency. Even USA has labeled China as currency manipulator! The past two G-20 summits has been dealing with this issue. The question is should China revalue it and let the currency appreciate or keep it as it is? Is that the appreciation of Chinese currency will solve the problem for USA and the rest of the western world? If so, then why the Chinese currency was kept low (if it is artificially) earlier? Or there are even bigger issues in this. This article tries to explain all of these and the issues within by going through the history of currency standard, why and how devaluation is done, and why it is that now an appreciation of Chinese currency has been repeatedly asked for? And why does it concern USA so much?History of Currency System:
For centuries European countries devalued their currency by decreasing the natural value. One of the popular methods was by decreasing the storage of gold which they call partial reserve system or by replacing gold by cheaper metals like silver or copper or even nickels. But until the 18th century the international trade was so little that these changes did not concern anyone. Then powerhouse Utmani Khilafah was all but self sufficient while Europe was just getting out of centuries of bloodshed and intense nationalistic fights within themselves which we know as Dark Age. Devaluation in Europe was also done through increasing the money supply. A mass form of devaluation was noticed during the Napoleonic wars. For European inability to produce much needed currency to support war during the First World War the European realized that, if they continue to use gold standard much of which is coming from other countries like African and middle eastern countries of Islamic Khilafah state, they resorted to paper standard. Thus after leaving the gold standard, during the great depression, European could now produce as much as paper currency they wish to produce by following partial reserve system or even fully paper standard. Since currencies now having no intrinsic value, devaluation became very common phenomenon. Since most nations were devaluing their currencies it had less effect and very few nations had long lasting benefit. Since random fluctuation took place, it discouraged international trade; as a result it fell steeply, affecting all economies. With this paper standard system they come to realize that without any standard intrinsic value behind the printing of currencies, there will be problem in fixing the exchange rates amongst currencies. This led to formation of Bretton Wood era (1944-1971) which was a fixed exchange rate regime. Letter on, in 1971 started the post Bretton Woods era (1971-1973) of semi-fixed exchange rates, it kept the exchange rates bit stable. The world saw some tremendous economic growth since trade amongst USA-Europe-Japan grew.
The War Begins:
From 1973-2000, there were minor devaluations but mass devaluation simultaneously was not present to call it a currency war. Most of the world wanted to strengthen their currency against their trading partners to instigate growth. The concept of free market economy reached the peak of acceptance after the fall of USSR with George Bush declaring the opening of new world order especially during the time of Clinton Administration. After the 1997 Asian crisis, many emerging nations faced rough terms from IMF and were forced to sell off their assets especially gold. Consequently lowering the confidence level on free–market economy and they started to intervene in the market and tried to keep the value of their currency low to have an export led growth. This also allowed them to build-up foreign reserves to counter future financial crisis. During that time none of the first world nations even though they were aware but not concerned about the undervalued currencies in different producing nations. In fact USA for example needed to purchase low priced commodities form Asian economics like China, India in order to reduce their balance of payment which has been negative since 1973. Indeed today the USA’s balance of payment deficit is 54% of the entire worlds’ balance of payment deficit. Thus countries like China was benefiting from an export led growth to USA and Europe while USA was having cheap products in its domestic market from China that supported their consumerism to grow as well as not letting its balance of payment not to become too large. So that was going okay for USA and China since at that time USA was enjoying quality goods at cheap price and maintaining a higher material standard of living as they had good financial status.
Until the recent economic crisis there were no complaints from the developed nations led by the mighty USA because they had the ability, and the exporting countries like China were maintaining a devalued currency. Now when they have problem, they are blaming it on these countries and trying to enforce initiative in their way. This is because with global financial and economic meltdown, US business has gone out of business; jobless rates are highest amongst the most of the high unemployment rate countries. Thus to help creation of jobs and to foster local business USA wants China to appreciate their currency so that the US firms enjoys advantage in the domestic as well as international market. This is why USA is pressurizing China. Before moving forward let’s consider the following facts.
· In September, 2010 Chinese imports grew 24.1 percent hitting a record 128.11 billion U.S. dollars.
· China's trade surplus in September, 2010 dropped 15.7 percent and to 16.88 billion. This is the lowest in the last five months.
· China's 2010 trade surplus is likely to shrink to about $100 billion in 2010 from about $190 billion a year ago.
· China's foreign exchange reserves rose to $194 billion in the third quarter, far exceeding the total amount of trade surplus and foreign direct investment made during the same period.
· China scrapped the dollar peg in mid-June and accelerated the pace of Yuan appreciation. The Yuan strengthened 2.3 percent between Sept 1 and Oct 22 against dollar.
· USA’s $1.98 trillion of the $4 trillion US Treasury notes are in the hands of foreign investors. Japan, the largest holder accounts of $680 billion and China $224 billion.
· China’s share in the US total trade is about 10%.
What Devaluation of Currency Does?
In paper standard countries who export more and seek to grow through exports generally devalue their currency. The devaluation of currency makes their goods cheaper, as a result sales increases. This increases the demand which initiates higher production. The higher the production the more the labor is required. Hence it decreases the unemployment rate and increases GDP. The devaluation also discourages imports of foreign goods and promotes export of local goods. But the action is not correct for a country which depends on imports, since this method may become deadly for them. Because they have to pay in higher amounts than they earn. This method is proven effective when there is imbalance in the balance of payments. Along with other benefits, this allows the country to secure high foreign reserves to cushion itself against future economic crisis. The devaluing country must have other advantages to support the devaluation, e.g.-cheap labor, capital etc.
This has a negative effect on the countries who are importing, as they become more dependent on cheaper goods. This discourages the local industry as their cost of producing the product is higher. This forces the country to import more and paying more to foreign countries.
Chinese Concern of Status quo:
China having cheap labor can produce goods at a very low cost and it enjoys huge competitive advantage. China is probably the largest exporter of different goods. Apart from that China has huge reserve of foreign currency (dollar) and large current account surplus. There is a chance that China might shift its economy towards domestic demand led growth. This will appreciate Yuan. If Yuan appreciates fast then there will be social and economic problems in China led by panic and bankruptcy of export oriented organizations. Fluctuation in exchange rate will demoralize exporters of China as a result increasing unemployment. In reply to USA’s continuous pressure, China said that if Yuan is allowed to appreciate, the price of Chinese product in china will increase but the American importers will shift to other countries who will offer cheaper goods. As a result USA will not benefit much. China also blamed USA for its qualitative easing policy the developing countries and emerging economies are harmed. China also argues that if she takes such initiative then inflation can sweep through all over the world with the help of the fruits of globalization! China held its Yuan pegged to US dollars at 8.3 Yuan per dollar for nine years. USA’s $1.98 trillion of the $4 trillion US Treasury notes are in the hands of foreign investors. Japan, the largest holder accounts of $680 billion and China $224 billion. China has started to appreciate its Yuan slowly recently. The Yuan strengthened 2.3 percent between Sept 1 and Oct 22 against dollar and increasing Chinese imports by about 24.1%.
USA looking forward for Restricting Chinese Imports:
If the US stops buying Chinese products, then US prices for products manufactured in China will go up – again big time inflation. As for textiles specifically, limiting only Chinese exports to the US will not stop the inflow of cheap textiles. No action has been taken to reduce the import of textile products from Egypt, Latin American and African exporters of products at prices lower than those of the US textile industry, so how will simply reducing Chinese exports alleviate pressure on the US industry?
If China chooses, or is pressured, to float the Yuan, the US dollar could fall as the Yuan rises. Once that happens, prices of Chinese imports could increase more, as will prices for those products in the US leading to higher US inflation.
If the Dollar falls enough, other countries that currently hold Dollars as central bank reserves, could decide to bail out of the Dollar so it does not drag their own currencies down. Even countries that simply peg their own currencies to the Dollar may decide to allow their currencies to float. The most likely US financial defense would be to raise interest rates significantly.
One considered opinion on the net effect of appreciation of the Yuan by an economist is, China gains its comparative advantage by low material and labor cost, highly efficient machinery as well as good quality control system. Hence, the appreciation of the Yuan would not exert too much impact on China’s comparative advantage and the US demand for Chinese exports. Besides, China’s share in the US total trade is only about 10%, and even if the Yuan appreciates by 20%, the real effect reflected on the US current account in dollar term will only be about 2%, which is too small to influence the US current account imbalance and relieve its unemployment pressure.
Possible Chinese Reaction:
If China were to cash in their bonds (US bonds) and demand payment in gold rather than fiat US currency, what would happen to the Dollar? Gold prices? The Yuan? At current prices there is not enough gold in existence to pay off all of China’s holdings of US Bonds. Because of a shortage of freely traded and available gold inventory, prices would likely need to increase by perhaps 8 times or more to make enough gold available to pay China! One might ask why then USA has floated such huge amount of its T-bonds? Indeed this serves an answer to the question of how USA is enjoying economic supremacy with other countries effort!
Indeed if China wants to cash in their US Bonds, the most likely scenario is that the US will merely print more Dollars as needed to cause a new skyrocketing Inflation. This is because USA does not have any backing to print its currency dollar. This is since the time of Nixon. How wonderful it is that, USA prints a one hundred dollar note with a mere printing cost of 6 cents. But once a country receives a hundred dollar notes, it receives it by paying real goods in the form of export or by giving service. Thus dollar becomes both a commodity as well as a currency for USA. Now if China tries to cash US T-bills it will have probably have a greater negative impact on the United States than a nuclear strike. It would appear then that China holds three trump cards:
· Remove Yuan peg to the Dollar (US inflation),
· Cash in their US Bonds (US interest rate rise, US inflation or much, much worse),
· Threaten to stop or reduce all exports to US (US mega inflation).
But the obvious question is whether the Chinese has the guts to take such actions.
Where it ends?
Technically USA cannot harm China much because of collateral damage scenario especially on economic front. It is clear that China enjoyed much of its economic success due to its cheap labor and technological advantage. But one of the most important reasons has been the weak currency which also helped the USA. Thus Chinese economic growth is based on a false model of intentionally lowering its currency value with apparent support from USA as well. However, with USA now backtracking, due to its internal jobless rates, business foreclosure etc. Chinese growth is really a paper one. So the G-20 summit is actively calling China to take some action for last one year or so and even to a point when America declared china as currency manipulator. Where this goes? How this world can solve this problem. Indeed no amounts of summits or policies are going to solve this problem for USA or China or the rest of the world! Indeed the solution lies on making a system where a country for example USA cannot automatically print paper currency without any backing of real assets and no other country should use that country’s currency as reserve to print their own currencies. As under current system USA is printing money without any restriction with the idea what they called “US’s Confidence Theory”. It is something that we must have the confidence on the US government as it prints money and makes Dollar as international currency standard. Which is very good business for USA! Thus we see form Nixon’s time till today even though USA’s GDP growth rate has been around 3-4%, their production of currency has grew at a rate around 18-21% over the year. This excess currency they have sold around the world for which USA virtually incurred the printing cost! This has also led to unprecedented growth in inflation across the world.
Moreover all the paper currency should be produced by having a standard real assets backing like gold or silver. However along with this we must make sure that any form of derivative business to destabilize the gold or silver market is strictly dealt with. The simple answer is that we have to go backwards and restart the real-asset backed currency. When currency is backed by a common real asset, we cannot keep our currency rate fixed rather it will depend on the real asset (a good example is the gold standard). Hence the problems regarding the exchange rate will no longer exist as in human history. This is exactly the reality of 1300 years of great Islamic Khilafah state which had a stable currency system with no noticeable inflation and currency problem.
For the western world who is sinking deep into economic crisis, the European who has seen their Euro which is not making life easier rather making it more difficult, for any economist who has been tired to find link between interest rates, money supply, exchanger rates etc, time is up to take the solution form Islam. Indeed Islamic Khilafah state for under its economic system provides a sustainable economic system to lift mankind from capitalist oppression in the form of price hike, inflation, cost of living soaring etc.
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