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China's Currency / Commodity Strategy

March 07, 2010 | About:
Harry Long

Harry Long

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Commodity prices and yuan appreciation are inextricably linked. While foreign governments can pressure China to allow the yuan to strengthen, most policy makers overestimate the influence that they have over foreign governments. Indeed, the number one influence on the yuan exchange rate is the price and the availability of industrial commodities.

Traditionally, countries with weak currencies have paid proportionally higher prices for commodities. China has escaped this fate by attempting a global commodity grab aimed at directly sourcing raw materials for its voracious manufacturing, construction, and energy industries. This is vertical integration at the national, as opposed to simply company, level.

Why is vertical integration so important to China strategically? Because in order to gain the full advantage of low-cost leader status through a weak currency, China cannot afford to pay higher commodity prices, which would lead to inflation and to higher prices for finished products, eroding the very cost advantage that a weak currency confers. Indeed, if commodity prices, denominated in yuan, spun out of control, China would be forced to allow its yuan to appreciate in order to secure commodities at economic rates.

Therefore, on a very real level, it is China's access to plentiful and cheap supplies of commodities that is allowing it to maintain a relatively weak yuan. Indeed, American policy makers would do well to take a page of out China's playbook and to secure cheap supplies of energy around the world if we wish to stave off inflation while continuing to debase the dollar.

During the Cold War, we had Mutually Assured Destruction. In our own time, if all nations imitated China, it would be a policy of Mutually Assured Devaluation. We can see it now in Europe, where the monetary debate has concluded with a consensus that the European Central Bank's conservatism has lead the Euro to appreciate against the dollar to such an extent that it has damaged European manufacturing.

The Chinese are not, contrary to popular opinion, practicing neo-Mercantilism at all. In Mercantilism, according to Adam Smith, countries equated Gold bullion, or hard currency, with wealth. The Chinese are under no such illusions. They correctly equate plentiful supplies of industrial commodities with wealth when paired with their manufacturing base.

The distinction is important, because a cheap supply of industrial commodities represents a long term cost advantage for Chinese industry independent of currency manipulation. The Chinese have learned from the Japanese experience and are intent upon securing commodity supplies to build upon their advantage of cheap labor with cheap input prices. Indeed, even the yen eventually strengthened. What were the Japanese able to source for cheap raw materials? The lumber from bonsai trees?

If we agree that China's access to cheap commodities lies at the heart of its ability to keep its currency weak—indeed, to have its cake and eat it too—we then must agree that China doesn't need to change. We do. The United States must also vertically integrate in order to better compete.

How can the U.S. successfully vertically integrate and maintain such integration?:

  1. We can aggressively develop domestic sources of fossil fuels and minerals.

  2. We can use military force to prevent foreign governments from nationalizing American assets.

  3. We can develop renewable energy sources at home.

  4. We can make high-impact/low-probability bets on fusion.

  5. We can out-bid the Chinese when they attempt to acquire foreign commodity supplies.

  6. We can build hundreds of new nuclear power plants.
However, doing nothing is economic suicide. U.S. policy makers are attempting to beat the Chinese at their own game and to engage in Mutually Assured Devaluation. If policy makers do succeed, the U.S. dollar will depreciate, commodities priced in dollars will sky-rocket, and interest rates will go sky-high.

Unlike China, which has an additional cost advantage of plentiful capital from its high savings rate, the U.S. has no such cushion. Therefore, in any Mutually Assured Devaluation, China would have comparatively lower real interest rates, further increasing its cost advantage, to say nothing of the fact that it would dramatically curtail its purchases of U.S. government bonds, further driving up U.S. interest rates.

I propose that the iron law of modern economics is that countries can be a net importer of capital, commodities, or goods, but not all three simultaneously if they want to achieve sustainable economic growth. The examples are numerous. Just examine Western Europe vs. Saudi Arabia, Brazil, and Asia.

Currently, the U.S. is a net importer of energy and a net importer of manufactured products. Ridiculously, the U.S. also imports (borrows) some of the capital to pay for them. Never have so few produced so little to consume so much. There is an old saying in Economics. “If something cannot continue forever, it generally doesn't.” With its global hunt for cheap commodity supplies, high savings rate, and cheap labor, China can keep its currency cheap almost indefinitely. We will have no such luxury, as the pain from a dollar devaluation will swamp any benefits. We no longer have the option to do nothing, nor to engage in a policy of devaluation. We literally have no policy flexibility—at least no policy option surrounding currency or interest rate manipulation which will work well in the long run.

We should be careful what we wish for. A dollar devaluation in relation to the yuan will not help us. Becoming a vertically integrated nation, with a plentiful supply of cheap commodities, will. Unfortunately, we will never have cheaper labor prices than China. However, we can have cheaper input prices. If we wish to compete, cheaper input prices are not optional—they are a requirement for maintaining our way of life and competing effectively in the global markets.

Disclosure: No positions


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