The Weiner Component #134 – China Devaluating the Yuan

Initially it is important to keep in mind that China today is the second greatest exporter and importer, coming after the United States, in the world.  She is a highly developed, mature, industrial nation.  She is no longer an aspiring Third World nation in the process of catching up with the rest of the world.  From June of 2014 to relatively recently the international value of her currency, the yuan, rose 25%.  For China to think or act like a Third World nation is idiocy.

 

However the Communist rulers of China and their economists have been very disturbed by their recent Gross Domestic Product (GDP) which has decreased from an average of about 8% per year to 2% or lower.  Since the rulers of China are more absolute than those in most other industrial nations the solution they agreed upon has been to devaluate their currency.  This process was begun on Tuesday, August 11th 2015.

 

When the news of this currency decrease hit the United States and other industrial nations the overall effect for their stock markets was to drop significantly, in the U.S. well over 200 points.  The U.S. DOW consists of the combined value of 30 chosen stocks.  Each point on the DOW is the equivalent of one dollar.  Their combined value dropped well over $200.  On Thursday, August 20th the Stock Market in the U.S. dropped again, this time 358.04 points bring it to its lowest level in a long time   Across Europe and Asia other countries Stock Markets also fell significantly.  On Friday, the 21st there was still another significant fall of an additional 530 points in the U.S. and additional negative results in other industrial nations around the world.

 

The only stocks in danger of seriously dropping in real value were those for companies that are based in China or those multinational companies that sell large amounts of goods to China.  And these particular stocks will later probably increase far above their initial value when the yuan eventually reaches a new state of equilibrium with all the other currencies.

 

For Apple and other companies who do quite a bit of their manufacturing in China, their profits should increase significantly in the short run because their labor costs will drop rapidly as the yuan is devaluated against their currencies.  The price of their goods sold in China will rise and that could affect their sales there.   Of course that will eventually reach a new equilibrium as wages catch up to the inflation in China.

 

If the leaders of China are successful in lowering the value of the yuan then Chinese goods and services shipped to other countries will be considerably less expensive and there will be a significant increase in their sales, overseas sales presumably increasing their GDP to 8% or better.  However many other Asian country seem to be following China’s lead.  The results should be interesting and confusing.

 

Three days after China began this policy she had dropped the value of the Yuan 1.9%.  The next day she devaluated it another 1.6%.  Will she be able to continue this process?  Probably not at that rate of decline.  Wanting to do something and being able to do it are two entirely different things.  The control the Chinese leaders would like to have over their economy does not really exist.  It is an erratic force.  It is almost like driving a car at high speed on an American freeway.  One can constantly go around slower vehicles easily if they continue at their set speed but one cannot predict when the speed of any of these automobiles change.  Sooner or later one or more accidents will occur.

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I remember as a youngster learning, in elementary and high school, about the discovery of the New World in the 16th Century and the phenomenal amount of gold and silver brought to Europe at that time over the century.  It was a heroic period.  What was never taught was the fact that all this precious metal in the form of money, gold and silver coins, entering the economies of Spain and the other European nations rapidly brought about a 90 year period of inflation while wages remain largely fixed.  The general population of ordinary citizens underwent great hardship for the duration of that century.

The Chinese government could be doing the same thing if they can successfully devaluate their currency sufficiently.

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For a nation to decrease the value of its currency significantly against that of other nations is a fairly complicated process.  The government economists and the leaders of China apparently made that decision in order to force an increase in national productivity, to bring the GDP back up to where it has been historically.  Their current rate of economic growth to them denoted the beginnings of a recession.  They seem to feel an intense need for more rapid expansion.  Reducing the value of their currency against the fixed general values of all other currencies, they believe, would bring about the desired outcome.

 

First of it is important to remember that money/currency has no real intrinsic value.  Each nation prints its own and that its money is only usable within its borders.  Specific monies are simply a means of exchange within the boundaries of each specific nation.  Its actual value is determined by the credit rating of each particular country.  And internationally the value of each currency continually oscillates slightly against the value of all the other currencies.

 

On July 1-22, 1944 toward the end of World War II, 730 delegates from the 44 Allied Nations met at Bretton Woods, New Hampshire, in the United States to establish the rules for commercial and financial relations among the world’s major industrial nations.  It was the first instance of a fully negotiated monetary system intended to govern monetary relations among independent nations.  Among other things they set the standards for all national currencies.  These standards were based upon the value of the U.S. dollar.  The dollar is still the base standard today.

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There are three possible ways for China to devaluate the yuan.  The first is to substantially increase the money supply within its own nation.  By over-increasing the National Cash Flow there is more money available than there are goods and services.  Here the laws of Demand and Supply apply.  People, in order to get what they need and want, will bid up the prices of virtually everything and the country goes into an inflationary spiral.  All prices rise quickly except wages and the value of the yuan now buys less.  Internationally the value of the Yuan will also slowly plummet.  This solution brings a lot of hardship to the people of the country initialing this move.

 

A second method is for the nation to rapidly increase its purchase of raw materials and goods from other nations.  Again the laws of Supply and Demand apply.  If much more materials are suddenly demanded/purchased than are ordinarily bought in regular trade then the prices of these items will become more expensive and prices will increase rapidly.  In this fashion the money paying for these raw materials and goods decreases in value.  This is the slowest of all methods of devaluation.

 

The third and probably most important method for devaluation is direct currency exchange.  Each individual nation has one or more banking houses, some of which are directly controlled by the government of the particular nation.  These financial institutions trade currencies with one another, regularly making large profit from slight oscillations in the value of their monies.  All currencies tend to rise and fall the equivalent of pennies in value continually.  This is caused by the laws of Supply and Demand.  If one bank buys several million in a currency that has dropped a half penny in the morning from another country and sells it for an additional half penny that evening or the next day then the bank has earned several million half pennies.  All in the period of one day.  Of course all these banks function mainly to exchange currencies for people visiting other countries or doing business between nations.  And all these exchanges are done for fees.

 

It should also be noted that the value of the yuan had been slowly rising at the rate of about 1% a month for the prior year and any nation that had an excess of yuans gradually reaped a goodly profit.

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If a country, like China for example, wants to cheapen the value of its currency then it sells an excess amount of yuans to currency dealers of other nations.  As the excess over what is needed for an ordinary exchange of goods and services between different countries grows then the value decreases and continues doing so until the yuan is reduced in international value to the level the Chinese government wants it to be.

 

Of course the process may take days or weeks or even months.  And as it goes on there may be potential chaos in one or more national stock markets.  This seems to be happening at present.  These operate upon the perceptions of many of the stockholders.  Many of which seem to function totally upon rumor or blind fear.

 

As of Monday, August 17th 2015 there had been two devaluations by the People’s Bank of China (PBOC).  The first was 1.9% against the U.S. dollar and the second was for 1.6%, making a total of 3.5%.   Will there be further currency devaluations?  The answer is possibly.  What will the result be?  Further chaos in financial markets and greater hardship for a goodly percentage of the Chinese population.

 

As a note of irony one of China’s current problems is that the yuan appreciated in value by 12% since June 2014.  If she had quietly devaluated the yuan by a ¼% on a monthly bases she might well have achieved the same devaluation without any other nation noticing what she was doing.   It is also worth noting that a Chinese company looking for a source of cheap labor is currently investing the equivalent of five billion dollars in a facility in India.  It seems that their profits would be greater by producing their goods in India rather than in China.  In the United States a Chinese entrepreneur bought a bankrupt auto parts company and he intends to produce all electric automobiles in his new company located on the West Coast, in Nevada. His comment was that labor was far more expensive but the workers are far more sophisticated.  He intends to sell his product in the Western United States.

 

China is no longer a country filled with cheap labor; it has become a modern industrial country; in fact, as stated earlier, China has the second largest economy in the world after the United States.  In the U.S. a 2% GDP is not overly exciting but it can be acceptable.  It still denotes economic growth.  China may have to make the same adjustments that other industrial nations have made and live with a far lower GDP.   She cannot recreate her past.

 

The world’s stock markets have gone essentially into a state of disaster or terror from China’s 3 ½% devaluation of the yuan.  What does this tell us about the sanity of the free market in stock sales?   As of Wednesday, August 25th 2015 the stock market in the U.S. reversed its downward spiral which had been well over 1,000 points and began to rise again.   This did not happen in Asian stock markets. On Thursday the U.S. rose again significantly. On Friday the U.S. stock market seemed to level off.

 

What will the following week bring?  An interesting question.  If the Chinese government and economists do nothing then the stock markets, including their own should continue to rise.  If on the other hand the Chinese government does something dramatic then there’s no telling what may happen.  It has been announced that they will lower their interest rate.