Why China Wants To Dump the Dollar – Chriss Street

This is a syndicated repost courtesy of Chriss Street and Company. To view original, click here. Reposted with permission.

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China 2013China’s Dagong credit rating agency on October 17th downgraded its United States sovereign credit rating to A- and maintained its negative outlook on America’s solvency.  Dagong warned that despite Washington’s last-minute resolution of the debt ceiling deadlock: “The fundamental situation that the debt growth rate significantly outpaces that of fiscal income and gross domestic product remains unchanged.”  China’s official state-run news agency, Xinhua, reiterated its statements  that because of the continuing risk of a U.S. debt default, it is “a good time for the befuddled world to start considering building a de-Americanized world.”  This language is code for Chinese want to abandon the U.S. dollar as the world’s “reserve currency” move international financial transactions to the renminbi, the currency of the People’s Republic of China.  Having benefited for twenty years from their under-valued currency importing manufacturing jobs and exporting lower priced products, China’s comparative advantage is being destroyed by America’s oil and natural gas fracking boom.  The Chinese communist authorities are terrified their loss of competitiveness will cause unemployment and the social consequences that flow from it.  But with the terms of trade now substantially against China, convincing the world to dump the U.S. dollar as reserve currency and switch to the Chinese “renminbi” is their best hope to try to save tens of millions of manufacturing jobs.

When the Soviet Union collapsed in the early 1990s, China’s economy began to implode and inflation skyrocketed from 10% to 25%.  The United States, Europe and Japan saved the Chinese economy by allowing China to devalue their currency by 68% and gain tariff free export to world’s largest markets.  Under this new communist form of capitalism from 1993 to 2008, China’s economy quadrupled, U.S. economy doubled, Europe rose by half and Japan stagnated.

Contract manufacturing is a very competitive business and historically had an average profit margin of only 3.5%.  This assumes uncontrollable costs of about 75-80% for purchased inputs and 13.5% for energy.  The companies primarily compete over managements’ ability to get more or less productivity from an average of 8.5% in labor cost.  But China’s labor rates were initially 75% cheaper than the U.S.  But with China’s labor rates initially 75% cheaper than the U.S., by moving production to China manufacturers could often double their profit margins to 7% of sales.  Once in China, manufacturers could also discount their sales prices to wipe out U.S. competition.

U.S. trade “experts” in 1993 expected Chinese workers’ total factor productivity (TFP) would be less than a quarter of American workers’ 1.25% annual productivity gain.  This may not sound like allot, but over a 15 year period Chinese manufacturers would produce a unit for 95% of original cost and U.S. manufacturers would be producing the same unit for 82% of cost.  The “experts” predicted few jobs would be lost to China and America would gain new markets for high tech manufactured goods.

Over the next 15 years, China grew the number of assembly workers involved in manufacturing for export to over 200 million workers.  America lost about eight million manufacturing jobs to China, 40% of our 20 million production jobs.  But even more damaging, every manufacturing job also lost four service jobs and another 1.58 manufacturing jobs from sub-assembly manufacturers who locate near their customer.

China understood that as it sucked manufacturing jobs out of the U.S., the Chinese renminbi currency would be expected to rise in value and destroy their “cheap” labor advantage.  As a communist nation, they adopted a national policy of recycling a portion of their export sales revenue into the purchase of U.S. Treasury bonds to drive up the value of the U.S. dollar versus the Chinese renminbi.

Fearing that every 10% increase in the exchange rate of the renminbi to the dollar would cause the loss of 35 million manufacturing jobs, by 2008 China had purchased $1.2 trillion in U.S. Treasury Bonds.  China’s bond purchases drove down U.S. interest rates and caused a real estate building boom employing millions of Americans.  But when the real estate bubble burst, the “Great Recession” educated Americans on the pain of losing manufacturing jobs.

China’s labor costs became even more uncompetitive versus the U.S. after 2008 financial crash drove down U.S. wages.  In response, the communist nation began “administering” input costs by subsidizing the cost its state-owned export manufacturers paid to purchase energy.  As a country that imports 70% of its oil needs, subsidies preserved manufacturing employment.  But the subsidized prices increased the demand oil and drove the international price of oil from a recession low of $40 up to $100 barrel.

The financial crisis caused such scandal in the U.S. banks were forced to slash their leverage risk down from holding $25 to $13 of assets for each $1 of deposits.  The Chinese authorities directed their state-owned-banks to increase leverage from $35 to $48 of assets for each $1 of deposits.  China banks also increased infrastructure and commercial and residential property loans.  Policy lending created such huge new inefficiencies in the Chinese economy, that many bank loans can never be repaid.

China’s steady growth in oil demand has led it to become the world’s largest net oil importer, exceeding the United States in September 2013” according to the U.S. Energy Information Administration.  China’s rising oil demand in September outstripped domestic production by 6.3 million barrels per day.  But U.S. imports continue to fall as fracking technology increased production to 7.8 million barrels per day, the highest level since early 1989.  Natural gas production is also rapidly increasing and America will soon be self-sufficient in this important industrial energy source.  The price for 1000 cubic feet of natural gas averages about $3.50 in the U.S., versus over $12 in China.

China remains an impoverished nation, where 900 million people have an annual per capita income around the same level as Guatemala ($3,000-$3,500 a year) and 500 million have an annual per capita income around the same level as Nicaragua ($1,500-$1,700).  China’s per capita GDP is around the same level as the Dominican Republic.  Stimulating the domestic consumer economy will not help manufacturers when the vast majority of Chinese cannot afford to buy the products they currently produce for export.

The Chinese benefited enormously from being allowed to devalue their currency and participating with the dollar as their reserve currency.  But if China continues aggressive lending to failing businesses, they will generate higher inflation and make Chinese exports more uncompetitive.  But allowing businesses to fail would cause unemployment and massive social and political problems.  If China sells their $1.6 trillion of U.S. public and private securities, the dollar will fall and America will become more competitive.  As China’s economic decline becomes obvious, it is doubtful they will convince the world to allow China to devalue and make the renminbi the world’s reserve currency.

China as the second largest economy in the world will continue to be a major international power.  But its days as the low-wage, high-growth center of the earth are over.  Their ability to project military power in Asia will also fade.  China’s future may be similar to what George Friedman of Stratfor famously said about the future of Japan after the end of its high-growth cycle: “it will play a different role.”

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