We saw the effect of foreign policy on both the U.S. dollar and the New York Stock Exchange when the EU announced a multi-billion dollar bail-out plan for Greece in May. Weeks later, American exchanges are still trying to recover despite a stronger dollar. This policy implementation did not even directly mention the U.S. dollar. Imagine the American economy's response if an even larger foreign policy centered on the U.S. dollar was enacted.
China could be changing how it handles the more than $300 billion it obtains each year through trade. Lately, the country has been purchasing U.S. debt like it's going out of style. In March, China, the largest U.S. debt holder, held $895.2 billion.Fear-mongers like to claim that China is simply biding its time, waiting to sell that debt to gain an economic upper hand over the United States. This would be catastrophic for the dollar. Imagine if one third of U.S. debt suddenly went for sale on the open market. Excessive supply of U.S. bonds would cause prices to plunge. The U.S. would lose its status as one of the safest investments in the world and would thereby lose the ability to finance most public, private and international programs.
But fear not. Not only is such a fire-sale unlikely, China's fiscal livelihood largely depends upon the continued purchase of U.S. debt. Unlike the Euro, the Chinese yuan is not on a floating exchange rate with the dollar; it is on a "managed floating exchange rate," which is a nice way saying that the communist government is manipulating the price instead of letting it find a fair market value.
Because the yuan is kept at a constant ratio against the U.S. dollar, a significant drop in the value of the dollar will simultaneously drop the value of the yuan. Hence, if the Chinese government implements policy which will drop the value of the U.S. dollar -- selling American debt -- the Chinese yuan will also drop in value on the world market. American debt is China's most valuable asset and seeing it lose value is not in China's best interest. Let's not forget that America is China's number one customer. All told, there is not much incentive to sell all that American debt.
Sorry, conspiracy theorists.
Why does China continue to purchase American debt?
And why won't it dump the debt it has any time soon? According to the U.S.-China Business Council, in 2009 the U.S. imported $296 billion dollars worth of goods from Chinese companies. America pays for the goods with American dollars. Because the dollar is not accepted as currency in China, the Chinese companies exchange their dollars for yuan at the central bank. China only purchased $69 billion dollars worth of American goods, which leaves $227 million in Chinese coffers. Instead of just sitting on the remaining cash, the Chinese government has used that money to buy the most secure and liquid investment in the world: U.S. bonds.
What is Currency Manipulation? The Argentinean Example
The manipulation of currency has been prevalent since most of the world dropped the gold standard. Indeed, currency manipulation can eliminate or aggravate debt.
Argentina found its currency in such a bind in 2002. The military-dictatorship had issued massive amounts of debt to pay for unsuccessful military projects. Coupled with its protectionist trade policy, there was little growth and even less competition to keep prices low. With the economy stagnant and unemployment rising, Argentina could not even pay the interest on its debt. To make the debt more manageable, it devalued its currency.
The principles of currency devaluation are quite simple. Say the currency of the hypothetical country "Distopia," the "Buck," is at a fixed 10:1 exchange with the U.S. dollar. For every 10 Distopian Bucks, you can buy one U.S. dollar. Let's also assume Distopia has 500,000 Bucks worth of debt (valued at $50,000 U.S. dollars). With devaluation, Distopia declares that now 1,000 Bucks can buy one U.S. dollar. Instantly, instead of having $50,000 worth of debt, Distopia now has $500 worth of debt. Pretty nifty... unless you are a U.S. citizen holding Distopian debt.
But back to Argentina; instantly after the devaluation, anyone who held original debt saw his holdings fall to almost nothing. Currency suddenly could purchase much less. Citizens started converting their pesos into dollars and sending them abroad, exacerbating the capital crisis. Inflation soared, reducing the purchasing power of the peso even further. Companies teetered on the brink of failure. Most international flights were cancelled, many banks failed as people lost confidence and withdrew all their savings and unemployment hit a staggering 25%.
As a helpful side effect, however, foreign cash could suddenly buy much more Argentinean goods. Foreign investors took advantage of the sudden discount. Exports increased dramatically and after a few years -- and a few more setbacks -- Argentina's economy seems to be heading back on track.
Devaluation is a dramatic measure not to be taken lightly. Yes, foreign exportation can help boost a struggling economy and the lessened debt burden may cause the economy to grow, but the economy's worth is instantly reduced. Additionally, future credit ratings will be lower, which stifles foreign investment in government bonds. Devaluation is rarely an attractive option, but often, there are no other choices to save an overleveraged economy.
So Why Does China Want to Keep its Currency Undervalued?
China has been receiving a lot of international pressure lately to revalue the yuan -- make it worth more. Its economy is booming and yet the yuan remains cheap on the world foreign exchange market. Just like Argentina's beneficial side effect, this means more foreign exportation. Chinese officials hope more trade abroad will outweigh the ails of a cheap currency.
China's economy is largely based on the exportation of consumer goods. Its booming population has provided excessive cheap labor, low incomes and low input costs. A cheap yuan keeps prices low and, so far, the economy is flourishing. Chinese officials announced their intent to cap inflation at 3% and GDP growth at 8% by the end of 2010. In the first quarter of 2010, China's GDP grew 12%, blowing that goal out of the water. Unfortunately, inflation is growing at a faster-than-desired rate as well. Is this good for China?
It is important to realize that "too much too fast," could indicate burgeoning bubbles -- a phenomenon in which prices become irrationally higher than the worth of certain goods. The impact of bubbles, especially in the real estate market, is still a fresh wound on the U.S. economy. China's booming real estate and retail markets could meet a similar fate if officials don't revalue the yuan.
China Can't Keep its Currency Cheap Forever
Keeping the currency cheap is generating economic growth for the export-dependent country, but the numbers may be misleading. The average Chinese worker doesn't yet have the income to purchase the things he makes: The economy depends upon foreign buyers.
This growth may not be sustainable. One of the easiest ways China could stave off this hyper-growth is by loosening its grip on the yuan-dollar exchange rate. Chinese economists do realize the implications of a perpetually weak yuan. Soon China will have no choice but to allow it to increase in value, but will manage it on its own slow terms.
Be mindful when it does. Thanks to Greece, we have seen the effect foreign currency manipulation can have on the worth of our portfolios.
Ways to Benefit from a Strengthening Yuan
If Chinese citizens see their yuan appreciate, each citizen can buy more products. That’s 1.3 billion people with more money to spend. Below are a few exchange-traded funds (ETFs) that track either Asian indices or specific sectors in China and can capture the benefits of that increased purchasing power.
iShares FTSE/Xinhua China 25 Index Fund ETF (NYSE: FXI) is by far the most popular (and therefore, most liquid) of the China funds. It invests 90% of its assets in the underlying index, which represents the performance of the largest companies in the China equity market. A more in-depth profile of this fund can be found here.
The objective of SPDR S&P China ETF (NYSE:GXC) is to replicate the performance of the S&P China BMI Index. The fund holds shares from about 120 companies based in China, and many of its top holdings are large, well-run firms (with less volatility than smaller companies). This fund also has the lowest expense ratio (.59%) of all the China ETFs.
SPDR S&P BRIC 40 ETF (NYSE: BIK) attempts to replicate as closely as possible the total return performance of the Standard & Poor's BRIC 40 Index, which tracks companies located in the emerging markets of Brazil, Russia, India and China. While the fund is made up of investments in all four BRIC countries, over 40% of its portfolio offers direct exposure to China.
iShares FTSE China (HK Listed) Index Fund (Nasdaq: FCHI) is an exchange-traded fund that seeks to replicate price and yield performance of the FTSE China (Hong Kong Listed) Index. The index (as well as the fund) represents many of the largest and most liquid Chinese companies.
iShares FTSE EPRA/NAREIT Asia Index Fund (Nasdaq: IFAS) aims to replicate the price and yield performance of the FTSE EPRA/NAREIT Asia Index, which measures the performance of companies involved in developing the Asian real estate market. It's portfolio includes Asian real estate companies and REITS specializing in everything from hotels to office space to residential areas. And like the BRIC fund, its holdings have the most exposure to China.