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April 13, 2005

Tariffs, Schmariffs ... and then GOLD
by Alex Wallenwein

Congress is about to do China a huge favor - unwittingly.

It is also about to cause the dollar to further drop in the forex markets.

In its attempt to slap together what it considers a "punitive" tariff and impose it on Chinese textiles, Congress is en route to making life far easier for the Chinese than it already is.

Their idea behind the tariff: Punish China for refusing to snap to a salute and revalue its currency on (US) demand.

The unintended effect: It will relieve China from the pressure of having to buy ever more (by now extremely unwanted) US dollars in order to keep its currency peg intact.

Think of it this way: What Congress (and the Bush White House) are complaining of is the fact that China enjoys an unfair trade advantage because its currency is so cheap relative to the dollar that Americans are virtually forced to buy ever more Chinese imports to assuage their over-leveraged monthly budgets.

Congress wants the Chinese to let the yuan climb in value relative to the dollar so American companies can compete better with Chinese products in the world markets.

Will the Chinese relent and revalue?

No. They'd be stupid to do that. (See below)

But what if the tariff is then actually imposed after they refuse? What will be the real effect?

For one, Americans will have to pay a 20% to 25% surcharge on all Chinese imports affected by it - so they'll buy less of them.

To China, that means less exports to the US, and presumably lower profits, to be sure. But it also means that China can take a much-needed breather from its self-imposed force-feeding of dollars

Since they will earn less dollars for their diminished US exports, their dollar-reserves will rise at a slower clip than before, which will put less upward pressure on the yuan, and that means they have less reason to sell yuan for even more dollars to keep their currency peg intact, so dollar-demand will be that much lower. (They will also have less appetite for US treasuries, putting further upward pressure on US interest rates).

Which will put more downward pressure on the dollar.

Which will make non-Chinese imports less affordable to Americans. A

nd since American products - due to high labor costs etc., - are too expensive for over-leveraged Americans, they'll have to go to the only place where the buying is still cheap - China.

Instead of textiles (on which the tariff is imposed) they'll spend more money on other consumer goods.

Bottom line, economically speaking, its a wash.

American textile manufacturers may rejoice, but Congress' intended effect will have been nil - except that China will then be seriously ticked off at the US, the yuan will still be pegged, Americans will still be buying mainly Chinese goods, the dollar will still continue to drop, the trade deficit will still keep on climbing (loading another straw onto the dollar-camel's back), etc.

Not a very good picture.

The only real difference is that American textile manufacturers will be getting a government-instigated (but consumer, i.e., taxpayer-funded) subsidy from which no one else benefits.

Will China Give In?

There is no way the Chinese will revalue their currency just because of this tariff. They have no reason to.

They are already working on the adjustment process. They know they have only until the end of 2006 to let their currency freely float under rules agreed to during their WTO accession. Speeding this vital adjustment process unduly is in no way in their interest.

They can live with a year and a half of lower textile exports to the US (they did live with them in the past, until as recently as 2004). But they can not live with the sudden, premature, loss of their entire export competitiveness.

Besides: what will American companies who have "outsourced" to China do when the yuan and the dollar reach near-parity? Their profit margin will be severely diminished. Sure, Chinese labor will still be far cheaper than US labor, but the currency advantage will be gone, and they will still have to carry higher transportation costs.

But eventually, in due time, China will revalue.

What About the Trade Deficit?

So, what about the trade deficit, then? Will it shrink as a result of revaluation?

Probably.

When the yuan climbs to its "market value" after the adjustment process (one way or the other), the last pressure-valve for US consumers trying to get more bang for their buck will be gone.

Walmart will have to raise its prices.

Americans will buy less "Chinese" - but will still not be able to afford US prices and keep consuming anywhere near current levels.

So they'll spend less.

US companies, in turn, will lose whatever "pricing power" they have left as a result, which will drag on profits - and therefore on the Dow.

And the dollar will inevitably decline against the yuan.

But not only against the yuan!

With the currency peg gone, China will no longer be needing to buy anywhere near the amount of dollars it must buy now to keep its peg in place. Other Asian exporters will now be more competitive relative to China since the yuan will rise relative to their own currencies, so they can export more to China and need to export less to the US.

So, they also will need to buy far less dollars to keep their own currencies low to the buck.

That will drop a rock onto the dollar-camel's already strained back.

And that means OPEC will get far less value for the dollars it gets paid for selling its oil.

They won't like that.

So they'll have yet another reason to be thinking about selling oil for euros - and when they decide to do that, the dollar is toast.

By that time, though, the euro may already be toast as well.

The Europeans can't agree n very much these days, so the constitutional ratification process is in jeopardy.

The Stability Pact lies in shambles, and the ECB's hands are tied because even the most light-handed credit policy is useless when over regulated and paralyzed economies can't come up with the necessary demand to take advantage of the cheaper money.

So, what remains?

First, the paper-trained world will rush to the yuan - but, ultimately, only gold remains. (The Chinese are already being told by their government to stack up on gold. One could only wish that our own government had as much foresight as the Chicoms.)

Got gold?

I sure hope you do!

Alex Wallenwein
Editor, Publisher
The Euro vs Dollar Monitor

Just like driving your car, investing only makes sense if you can see where you are going. The Euro vs Dollar Monitor is your golden windshield wiper that removes the media's greasy film of financial misinformation from your investment outlook. Don't drive your investment vehicle without it!

Copyright © 2003-2008 Alex Wallenwein

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