Saturday, May 31, 2008

How We Ripped Off China

Everyone thinks that China is taking advantage of us by exporting so much stuff to us, but it’s actually the other way around. The United States has taken a mountain of iPods, cameras, computers, and keychains and gave China nothing but pieces of paper in exchange. Americans get lots of stuff cheap and the Chinese are left with nothing but pieces of paper for their hard work.

Here’s how it works. China paves over thousands of acres of its best farmland to make industrial parks, builds factories, hires millions of workers, buys oil, aluminum, copper, etc., and makes tennis shoes, TVs, power tools, Christmas ornaments, you name it, and sends them over to fill the shelves of our Wal-marts, Toys R Us, Bed Bath n Beyond, etc. We buy physical objects that make our lives more enjoyable at extremely low prices and send the Chinese pieces of paper that say they’re entitled to cash the paper in to get a wheelbarrow-full of dollar bills.

Now what does a Chinese factory owner do with a wheelbarrow-full of dollar bills? Well, he has a couple of options. He could spend the dollars to buy some U.S. goods to make his life better. Or he could take the dollars to a Chinese bank, exchange the dollars for Chinese currency (renminbi) and buy Chinese goods. Well, as it turns out, the United States doesn’t make much stuff anymore, and the stuff we do make is a lot more expensive than Chinese stuff.

Suppose our factory owner wants to buy 10 lbs of apples. That would cost him roughly $20 at U.S. prices. If he took that $20 and converted it into Chinese currency a couple of years ago when the Chinese exchange rate was 8 RMB/$, he could get 160 RMB. The price of apples in Beijing in 2006 was about 2.75 RMB/lb, so he could get his 10 lbs of apples from a market down the street for less than 30 RMB. Then he would still have over 130 RMB left over, enough for a nice multi-course banquet in a Beijing restaurant.

This is a no-brainer. Trade in those dollars for RMB and buy Chinese!

Now the bank is stuck with a pile of dollar bills. What do they do with them? You’ve got lots of Chinese factory owners trying to trade in dollars for RMB. Only a few Chinese are trying to get dollars to send their kid to some American prep school or to go on a junket to Las Vegas and Hawaii. Normally, when you’ve got more people trying to unload dollars than are willing to take them, the price of a dollar goes down. Eventually, the bank is going to say, “Enough, already. I’m not going to take any more dollars unless you take less RMB for them.” When the price of dollars goes down—in finance lingo, the dollar “depreciates” and the RMB “appreciates.”

China’s money gurus don’t want the RMB to appreciate too fast. If the RMB appreciates to, say, 4 RMB/$, that 10lbs of American apples now costs only 40 RMB, just a little more than the Chinese apples. Chinese people might be tempted to buy American apples instead of Chinese, putting Chinese farmers out of work. Therefore, to keep the factories and farms humming, China’s central bank offers to take as many dollars as Chinese folks want to give them at a fixed rate of, say, 8 RMB/$.

So now the central bank is inundated with a mountain of dollars. What do they do with them? A dollar isn’t much good in China, so they send them back to the United States. But instead of buying physical things that actually make peoples’ lives better, they buy securities—Treasury bills, bonds, stocks, etc. These are pieces of paper that entitle the owner to get money back in the future.

The bottom line: China sent us goods that we wanted, bought, and (hopefully) enjoyed (we exclude the exploding tires, killer pet food, and the $20 CD player that broke after 2 weeks), and in exchange China got pieces of paper.

But didn’t the Chinese factory owners buy Chinese goods with the RMB they got for cashing in the dollars? Well, here’s a complication. If China’s money gurus let all these factory owners spend this flood of RMB with no constraints, you get a frenzy of spending, and “too much money chasing too few goods.” With everyone out there spending all this new-found wealth in the Chinese economy, merchants figure they can jack prices up. If the torrent of spending is big enough, you get inflation. In order to sop up some of these surplus RMB, the Chinese government sells bonds. Bonds are like a sponge or a paper towel. Banks give the government RMB and they get pieces of paper called bonds in return. In effect, they have forced the country collectively to save--to postpone spending those RMB until some day in the future.

When you sell more goods than you buy, you’re saving. Most of us do this in our younger years—we sell our labor for wages, and set aside part of those wages as savings. When we retire, we spend more than we earn. China is the young man socking away savings. The United States is the old man spending the kids’ inheritance.

This process can’t go on forever. China kept building up a bigger and bigger pile of dollars. Their total foreign exchange reserves is now about $1.5 trillion. That’s over $1,100 for every person in China, or about half of a typical Chinese annual salary. China (and other Asian and Middle Eastern countries) kept sending dollars back to the financial markets to buy more and more bonds and stocks. The flood of dollars coming back over the border pushed up securities prices and kept interest rates low. The low interest rates pushed up housing prices to the stratosphere. Americans built ever-bigger houses and bought more and more furniture and appliances, SUVs for the driveway, and exotic vacations. We were living the “Life of Riley” or perhaps “The Great Gatsby.”

Millions of Chinese are living better, too. But instead of a 5,000 square foot home with marble counters, Jacuzzis, etc., a Chinese family is thrilled to have a 500 square-foot condo a 90-minute bus ride from the office. And the factory workers who actually make the stuff we buy are ecstatic to live in an industrial park dormitory 500 miles from their home town and be locked down in a factory doing the same repetitive task 12 hours a day while breathing toxic fumes.

We kept this game going for quite a while, but what Washington Post columnist Steven Pearlstein labeled the "Mirage Economy" might be coming to an end. The housing bubble finally popped and China is having trouble keeping its inflation from getting out of hand.

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