Should we Fear China? — Part II
Tuesday, April 11, 2006 | Teeka TiwariRating:
Last week's article on the US/Chinese trade deficit sparked a number of questions and comments from several of our readers, and I wanted to answer some of them for you today. Stan W writes:
"Today, Teeka gave us some commentary on China and the effect they have on our economy. How about a little more explanation - even some nuts and bolts details - of how the current account and the trade deficit affect us all. I sometimes get confused over the inter relationship between the two deficits and how they affect us. Teeka's article gave me a little more insight, but maybe there are other readers who would also like a little more of the " economics lesson" on the current account and trade deficits in particular with even a little discussion of how foreign currency exchange rates work. Teeka mentioned that some say China's currency is about 40% undervalued - exactly how does all this tie together?"
Stan, thanks for your questions. For the newbies out there, the current account is the difference between a nation's total exports of goods, services, and transfers, and its total imports of them. We are said to be running a "trade deficit" when we import more than we export.
Running trade deficits is not necessarily a terrible thing. Politicians fret over trade deficits because, when a nation buys more than it sells, it creates a drain on the country's resources. The country's wealth literally flows away from it into the hands of foreigners.
It's analogous to what's happening to the average American today with personal debt. The average American is so highly leveraged that he/she is essentially giving the bulk of their future wealth to somebody else. The same thing that happens to people happens to countries: When they spend more than they take in, they go broke.
This is a problem for most other countries because that money never gets spent in the home country; so that wealth is literally removed from the home country's system, thereby slowing down the velocity of money and its attendant wealth effect.
But that's not how it works in America. You see, we ARE the global economy, and so of all of those hundreds of billions that we shuttle off to Japan, India, China and the Middle East (via our oil buying), a massive portion of that wealth gets REINVESTED back into American stocks, American real estate, American Venture Capital, and (the vast majority) into AMERICAN Bonds.
What this means to us in America is that we get low interest rates (the more people buy our bonds, the lower our interest rates go), which leads to housing booms and real estate wealth creation. It means we get robust stock market valuations, highly liquid financial markets, and a plethora of other advantages ranging from new job creation to brand new medical devices and drugs developed from the billions poured into American venture capital companies.
Our trade deficit is clearly a virtuous cycle that hundreds of millions of people benefit from every single day. Without our consumers, China cannot finance its leap into the 21st century, and without China's buying of our treasury bonds we cannot support our huge budget deficit (the gap between how much the US government takes in and how much they actually spend).
More importantly than all of that, though, China has a huge stake in keeping our currency strong.
Let me explain: The stronger the US dollar is, the cheaper Chinese goods become to American consumers … and the more we buy from China. A strong dollar means that you can buy more Chinese Yuan for each American dollar. Conversely, the weaker the US dollar becomes, the more expensive Chinese goods become to American consumers, because now the same US dollar buys you less Chinese Yuan - meaning you have to spend more dollars to buy the same amount of Chinese goods.
David L., another one of our readers, wrote a great commentary on the current trade imbalance that captures the essence of the problem and the solution … all in two paragraphs:
"It's great to see that Teeka has a better understanding of the reality in relation to the US deficit than so many of the other experts I see. While the point is frequently made that US consumption fuels the world's growth, it is equally true to say that China and Japan are funding that consumption and growth and in the case of Japan that has been at the expense of its own growth. While promoting an environment that will ultimately bring both US and Japan & China back to a situation of more balanced external balances will ultimately be in the best interests of all parties, rushing the outcome is more likely to result in a negative outcome than simply creating the environment that will produce the required result.
For the US, this means reducing our Budget deficit to reduce consumption and the demand for external funds, for Japan and China this means promoting an environment that will increase consumption and imports. The market has the ability to deal with the environments created if those actions were taken particularly when they are moving closer to balance. In the meantime, US companies have a cheap source of offshore labour, and US consumers have access to cheaper goods. What is wrong with that?"
For the US, this means reducing our Budget deficit to reduce consumption and the demand for external funds, for Japan and China this means promoting an environment that will increase consumption and imports. The market has the ability to deal with the environments created if those actions were taken particularly when they are moving closer to balance. In the meantime, US companies have a cheap source of offshore labour, and US consumers have access to cheaper goods. What is wrong with that?"
David, I couldn't agree with you more. Many in Washington forget that the free market is a self-correcting mechanism, and left to its own devices it will sort itself out. Although for most puffed up politicians, that thought just may be too much of an anathema for their poor egos to handle!
"Let the Game Come to You."
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Teeka Tiwari
Chief Investment Officer
ETF Master Trader
