China is always one of the more controversial topics that we cover,
but as the world’s second-largest economy,
that is home to a radically different market system than the US, it is almost inevitable
that the nation is just a great opportunity to see a lot of interesting economics in action.
In fact a lot of that controversy actually comes from the way that the nation handles its economy
and what there actions mean for workers in consumers in the western world.
Chief amongst these concerns is trade. Pretty much everything is made in china, from low-quality
disposable toys to high-end electronics the nation has become the workshop of the world.
To the USA, which rose to its prominent position today by
also once being the workshop of the world, this can seem very threatening.
This perceived threat true or otherwise has led to hostilities like the US china trade war
as well as a host of other trade tensions between China and other
nations as it spreads its influence over the world.
Now we are not here to speculate over china’s plans for world domination. But instead,
we are here to use this tension to explore something that has come up
time and time again out of all of this.
And that is he idea that China is not playing fair in the game of global trade,
and that they are cheating other countries, companies,
and consumers out of business by Manipulating their own currency.
So how does a nation like china control their currency?
Can this actually be used to give an unfair advantage in global trade?
If it can, why doesn’t every country do it?
Can businesses profit of this man-made market failure?
And does a currency price even matter?
At the end of the day someone could go to japan and be a millionaire because their currency has
such a low value, but that doesn’t really mean anything for global trade or our would be baller
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Now just the phrase currency manipulation has a sinister
vibe to it. It’s almost never good to be called out for manipulating anything.
But is this more a case of bad branding,
or is this a genuine underhanded attempt to ruin their competition?
Well perhaps the best way to asses this is to look at how a nation actually does control their
currency, and by extension how this impacts, Price competition
In general, most nations want to export lots of goods and services,
and import only what they really need to.
This relationship of imports vs exports is noted as a trade surplus if a nation exports
more than they import or trade deficit if they import more than they export.
You have no doubt heard a lot about
trade surpluses because they are a pretty commonplace political football.
A trade deficit sounds bad and politicians will use this to scare people into thinking that
their nation is losing the ability to make anything for themselves.
Which can actually be somewhat true.
Free trade is almost always a good thing for the overall wealth and prosperity of the nations
engaging in that free trade, but this prosperity can often come at the expense of local industry.
For example, the UK used to have a very strong auto industry,
with a local branch of General Motors operating in the nation,
under the name of vauxhal, as well as the usual group of mini, rover, jaguar ect.
This industry employed tens of thousands of workers and they made,
just, absolutely terrible cars.
Now I know I know, I can hear the rage in the comments already, some of these cars were cool,
and today they are classics but the average consumer runabout that came from these
companies left alot to be desired by their german, japanese and even american rivals.
Now they could get away with producing these lemons because
the government was looking out for them.
If these international competitors wanted to sell a car in the UK
they were more than welcome to do so, but they would have to pay import tariffs.
These are taxes levied on imports and they could be pretty steep. A toyota corolla that might
have competed with a Vauxhall Astra on price in a perfectly fair market,
but if the Japanese manufacturer had to pay a 30% import tariff,
then they would have to pass this expense onto their consumers making the foreign car
just simply too expensive for most households to consider over a domestic manufacturer.
This is part of the reason that if you watch old movies or TV shows,
having something like a Honda was actually a pretty decent flex. (cut scene)
Now these import tariffs were great for keeping local businesses operating,
and be extension their employees employed but it was still a net loss overall.
The world is much better off today where everybody can buy a decent car for a decent price,
produced by businesses that have to compete and trade internationally.
As nations realize this, barriers to trade,
like the aforementioned import tariffs have become less and less common.
Never the less some nations are still looking to get a bit of an edge in less obvious ways.
Chief amongst these techniques is lowering the value of their own currency artificially.
Now a low valued currency sounds kind of bad. If you hear a news
report saying the Japanese yen lost 3% of its value overnight.
Your first question might be oh no… what has 2020 done to japan!?
But in reality there are some big benefits to having a low valued currency.
For starters, if your currency is less valuable then importing stuff becomes more expensive.
If someone is tossing up between a Cadillac and a Mercedes,
they might be pretty cost comparable. If the US dollar looses half its value though,
then that Mercedes is going to be twice as expensive to purchase because it is going
to take double the amount of American dollars to pay the german auto manufacturer in euros.
This means that the American car buyer will just stick with the caddy and hey look,
American auto manufacturing lives to see another day.
This achieves the same thing as the tariffs we were looking at earlier, but it does not break
the rules of any trade agreements that will normally stipulate that tariffs are banned.
The opposite is also true. If a german was making that same decision, then they would
suddenly see that for the same portion of their euro-based savings they can now buy two Cadillacs,
making it a more tempting proposition than their local offering from Mercedes.
Now obviously any self-respecting german would not be caught dead
driving a Cadillac so this example is a bit oversimplified but it still goes
to show that a devalued currency is a big win for local industry.
A question that a lot of people ask here is well, wouldn’t prices adjust to reflect this?
I can go to japan and trade-in 10,000 usd’s for 1 million japanese yen,
but that hardly makes me a millionaire right?
And thats correct, 1 million yen probably has about the same purchasing power as as $10,000 usd.
In reality probably less given the cost of living differences in japan vs the united states.
Over a long enough time frame, free-floating currencies will normally even out on purchasing
power, even if it means that the nominal figures are different.
But, and this is the important distinction here!
A nation like China is not de-pricing their currency, they are devaluing it.
Price and value are terms pretty strongly related to one another,
so if you are still confused think of it like this.
Apple shares are about to be split in 4. What this means is that someone holding 10 apple shares
on on 27th of august will wake up the next day with 40 apple shares. Sounds pretty good right?
The only problem is, of course, these shares will now be worth 1 quarter what
they were previously worth, so our would-be investor hasn’t really made any money off
this split (all other things being equal) The benefit of this though is that apple
shares are now easier to invest in, because small-time traders can get in for 100 odd dollars,
rather than the 400 plus dollars per share apple is currently trading at.
But 1 apple share, 4 quarters of an apple share, $10,000 usd’s, 1 million yen.
These pairs all have the same VALUE. 1 apple share today will pay the same dividend as 4 apple shares
next week and I can buy the same Gaming PC for $10,000USD as I might with 1 million Japanese yen.
What china does with its currency is not like what Apple is doing with its
shares to lower its trading price, it is more like Apple trying to push its share price down
50% without changing anything else.
Now apple would never want to do this because it is owned by shareholders,
who want to see healthy returns on those shares. But for all of thes reasons we saw before,
a sovereign nation like china, may want to do this with its currency.
So the only other question is
How is this even possible?
Economists will talk at length about the guiding hand of the market, how its impossible to fight
the market and win, and how everything eventually moves towards equilibrium.
So how is it that China is apparently fighting
this unstoppable force to push its own currency down?
Well, it is actually pretty ingenious.
They use market forces to their advantage by effectively becoming the market.
In the regular foreign exchange market there are hundreds of thousands of entities
buying and selling and trading currencies.
This can be anybody from some schmuck at an airport cash exchange trying to get some spending
money for their holiday all the way up to godman sachs exchanging billions of USD’s for Euro’s.
But the market for Chinese currency is a little bit different.
The Chinese government says that this is the price and that is what it is.
For argument’s sake, lets say it is 5 RMB for every 1 USD.
To make this happen the government will set up their own exchange where anybody
and everybody can come in to trade 5 RMB for 1 USD, or 1 USD for 1 RMB.
So long as they can keep on facilitating this trade that
is what the price will be. To see why consider this.
Lets say you are planning a trip to shanghai and you need to exchange
some american dollars to RMB to pay for everything while you are there.
If someone offered you 4 RMB for every 1 USD you would tell them to get stuffed,
because you can just go to the government exchange and get 5 RMB for every dollar.
The opposite is also true, because nobody is going to be willing to give
you 6 RMB for every 1 dollar because they would be better off going to the
government exchange where they would only need to pay 5 RMB for every USD.
So long as that exchange is functioning to determine both the buy and the sell
price of RMB that price is not changing.
Now one big drawback of this system is that the government will need to
maintain this exchange and keep a lot of foreign currency on hand.
If someone wants to trade in 2 billion RMB for 400 million american,
they are going to need 400 million american dollars.
Now collecting keeping that much cash handy is expensive!
Remember they are not just controlling their currency against the USD either, so they need to
keep euros and pounds and yen, and it actually costs the chinese government a lot to do this.
Fortunately, though they no longer need to service a majority of this trade.
Because people have learnt to accept that 5RMB is 1 USD they will just trade
amongst themselves at that price to make it easier, always knowing in the back of their
mind if the price deviates at all they can always go back to the government exchange.
Curiously enough, the expense involved in managing this exchange is very
similar to the cost borne by society through the tariffs we saw earlier.
Now this gets extremely technical, but an import tariff creates what is called a dead weight loss
on society. Go watch our video on the economics of the black market to learn more about that.
To acheive the same trade advantage the cost bourne by managing an exchnage
would be equal to the deadweight loss experienced through a trade tariff.
The only difference is that the exchange is paid for by the government directly with tax dollars,
and a deadweight loss is paid indirectly by tax payers with higher prices.
I will leave a journal article in the sources and citations listing that goes over this
in much more detail for the uber nerds amongst you who are interested in that.
But otherwise, the take away is this.
Messing with free trade is gonna cost ya, sure you can prop up local industry,
and maybe the benefits will outweigh the costs in the short term, but either way,
if you want to mess with mr market, expect a slap on the bottom line.
Now for the euntrapanerial amongst you, maybe you heard the phrase
market inefficiencies and the lightbulb is going off that hey! Market inefficiencies
mean there is a profit to be made by taking advantage of the inefficiency.
So how would one do that here?
Well your USD’s are technically overvalued in china, so you take them over there and
use that money to buy anything. It could be a car, a piece of furniture, a phone,
whatever it doesnt matter, what does matter is that you are going to be able
to get more stuff for your USD’s than you would have otherwise been able to in america.
Once you have secured your goods, you bring them back to america and sell them for a price
without the influence of undervalued foreign excha,,oooohhh wait a second,
this is just importing stuff from china to sell!
Congratulations, you have made a profit,
but you made it by playing the game that china wanted you to play all along.
Final thoughts
Currency, international trade, market intervention, chinese business practices
and foreign exchnage are by their nature, all very complicated issues.
If you throw all of these factors into a blender together you get
the controversy around currency manipulation.
So is it something to be angry about? Well yeah sure, but only as angry as you would be
about a trade tariff, which I am going to go ahead and assume for most of you is not very.
What’s more, is that every day china is loosening its grip on its currency.
Today RMB is influenced by market forces and is only occasionally beat back into line.
Realistically in the not too distant future, it is likely to become a fully free-floating
currency which will position RMB to become a more widespread and universally accepted currency.
Perhaps one that would rival the USD, but more about that on our next video in the series.
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