To Peg or Not to Peg?

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While I attended an economic conference last week in Shanghai, I found it notable — but not surprising — that two former Secretaries of the Treasury, John Snow and Hank Paulson, as well as current Treasury Secretary Tim Geither, and former President George W. Bush were then in the country at the same time. The fact that so many key American power brokers (myself not included) were in China simultaneously is no coincidence. In an overly indebted world, the $2.5 trillion that China holds in foreign reserves is acting as a center of economic gravity, inexorably pulling all market participants into its orbit.

When a 10-ton elephant plods through a village of grass huts, the big question on everyone’s mind is: which way is he going to turn next? With China, that fundamental question translates to guessing when Beijing will make changes to the value of the yuan. These decisions will determine the overall direction of the global economy, and will set the path that everyone must follow. Unfortunately, no Americans, even those who travel hat-in-hand to China, have a seat at the table where these decisions are being made.

At the risk of beating a dead horse, let me reiterate my central thesis with respect to currency valuation: just as it is always better to be rich than to be poor, it is always better to have a strong currency than a weak one. Although this simple maxim puts me into conflict with much of the economic establishment, I hold its truth to be…well…self-evident.

The effect of current Chinese currency policy (which, despite Beijing’s protests to the contrary, is manipulation pure and simple) is to make the U.S. dollar more valuable and the yuan less valuable. As a result, the benefits of manipulation accrue to Americans, not the Chinese. We get pay raises; they get pay cuts. Americans use their stronger dollars to buy products they would otherwise not have been able to afford. On the flip side, the Chinese people do without products that they otherwise would have been able to afford had their government not transferred their purchasing power to us.

The same effect is experienced with interest rates. In order to manipulate the dollar’s value higher, the Chinese government has gobbled up more than $1 trillion of them. The Chinese then loan the dollars back to the U.S. through purchases of government and mortgage-backed debt, which reduces the cost of servicing our massive liabilities.

By the same token, if China were to stop manipulating the dollar higher, it would remove the props currently supporting our dysfunctional economy. American interest rates and consumer prices would soar, and our economy would collapse. Meanwhile, China would experience the opposite effect. Chinese consumer prices would fall, immediately raising living standards for average Chinese workers, whose higher real wages would finally allow them to fully enjoy the fruits of their labor.

What strikes me as particularly dangerous is that no one, not even the Chinese, appear to understand these fundamental dynamics. All of the Shanghainese with whom I spoke last week were unaware that a stronger yuan would be in their own best interest. The way most people see it, a stronger currency is a bullet that China must be prepared to take in order to save the rest of the world from further pain.

And so we watch the strange spectacle of China stubbornly resisting actions from which it will immediately and substantially benefit. In reality, an appreciating yuan is the bitter medicine Americans must swallow if our sick economy is every to regain its health.

When Beijing finally comes to it senses, the transition will be unavoidably disruptive. For China, the long-term growth would far outweigh the short-term shock. America, however, would face a much less certain outcome. There is no question that, for Americans, the immediate effects would be very painful, with the gains only developing with time and prudent decision-making. Still, that does not mean we should resist the process, for the longer it is delayed, the more severe the pain and the longer the road back to prosperity.

Given this reality, why are our political leaders so adamant that China effectively pull the rug out from under our economy? Are they really that clueless? Perhaps they are — or perhaps they are a bit more devious. Perhaps they are using reverse psychology. Maybe they feel that the best way to get the Chinese to maintain the peg is to demand that they remove it. Historically, the Chinese have always resisted outside interference.

However, to paraphrase Abraham Lincoln, you cannot fool all of the Chinese all of the time. Soon they will see the light, and when they do, it’s lights out for American hegemony. If you think China is important today, just wait a few years. For example, while the Chinese automobile market is now the largest in the world, 90% of Chinese car buyers pay cash. In contrast, only 15% of American car buyers do so. In other words, Chinese consumers can actually afford their cars, while most Americans cannot. Without huge car payments, Chinese consumers are in much better shape not only to trade up to newer cars in the future, but to purchase other products as well. This suggests huge future growth, not only in automobiles but also in other consumer products as well.

This eruption of consumer demand, made possible by pent-up savings, is creating historic opportunities for investors. When the Chinese start using their wealth to expand their own economy rather than to subsidize ours, infrastructure may well be a primary beneficiary.

Whenever the Chinese government decides to end the peg, the Chinese economy will benefit as a result. While as citizens we can hope that U.S. leaders respond with the right policies to enable our economy to regain its former glory, as investors we should position ourselves to benefit from the more certain outcome.

Peter Schiff is president of Euro Pacific Capital and author of The Little Book of Bull Moves in Bear Markets and Crash Proof: How to Profit from the Coming Economic Collapse.

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