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Time to Break the Chain

Quint Tatro

Shanghai, China – I recently embarked on what would be one of the most memorable trips I have ever taken, spending more than one week in China with Commerce Lexington, the Greater Lexington Chamber of Commerce. From start to finish, this Chinese Government-subsidized visit was jam packed with adventure, as we toured four cities, multiple industries and countless historic locations. The ancient history alone is enough to impress anyone, however I returned home with a slightly variant view of my travels and a fascinating outlook on where this communist country may be headed into the future.

Unless you’ve been living under a rock, you are well aware of the strength the Chinese economy has shown over the last several decades, primarily due to America’s insatiable demand for cheap goods produced in China and exported to the United States. Of course, this is a result of countless U.S. companies relocating their manufacturing plants to a country where the minimum wage has recently been raised to approximately $200 a month, a pale comparison to the $1,256.67* monthly minimum wage in the United States.

The economic life-cycle of all of this has really been quite simple. Over the last several years, competition for profits has increased in the United States substantially, as consumer appetites for goods have risen considerably. With much higher employment costs due to such things as pension obligations, health care, insurance and a deteriorating work ethic, U.S. companies have had to look elsewhere to increase margins. Furthermore, as our “want it all now” attitude has exploded, no longer are we a society that possesses one family car, but rather two or three. Each room in the American house possesses a flat screen television, and the gadget demand has reached an unbelievable level. Of course, there are two sides of every story, and we cannot forget that over the years, due to this manufacturing transition, product prices have come down considerably, allowing most Americans to improve their standard of living while saving money. Rarely does a family experiencing hard times venture to the local thrift store when they can buy similarly priced new products at their local Walmart. Of course, this has come at the expense of U.S. jobs and foreign substandard labor practices, but the lower prices have been enjoyed by most, whether they realize it or not.

This economic phenomenon is not isolated to the United States but has spread to other countries all throughout the world. Despite what we view as a considerably low wage, it has served to create a middle class in China that never existed before in this massively populated, incredibly poor country. After the economic wheels began spinning because of foreign involvement, the engine started to roar, as Chinese families who previously had no means of earning money outside of local farming now earn a much higher wage for their time and effort. This, too, created a Chinese demand for goods and services in their own country, resulting in what would rival our U.S. Industrial Revolution among the 1.3 billion people of China.

For most of you, this economic history lesson is understood, however there are a few nuances still worth noting. First and most importantly is that China remains a communist country. This must not be forgotten, as the economic growth has not come due to a democratic dream but rather a well-concocted plan, executed with finite precision from a small minority of Communist leaders. Most major corporations or profit centers in China are government-owned and therefore the government is the largest employer by far. While this new boom has allowed many to prosper in China, we cannot forget that the majority of gains have been captured by the Communist leadership, with a vested interest in keeping the machine running at full speed.

The other item worth noting, and in my opinion by far the most important, is the fact that the Chinese currency, the yuan (pronounced “un” when spoken rapidly and meshed together, unlike all media correspondents who pronounce it “youwan”) is fixed, or “pegged,” to the U.S. dollar. You see most currencies in the world move up or down against other currencies in relation to their earnings strength against whatever country it is measured against. Commonly referred to as “floating,” a currency will always be quoted against another currency, for example, the U.S. dollar vs. the euro, or U.S. dollar vs. the yen. Unfortunately, we have a vastly misinformed American population when it comes to fiat currencies (another fancy name for paper money), which mandates I head down this road for just a moment.

To better explain, let me use an example that has always been helpful for me. A country’s currency can be equated with a company’s stock price, with the difference being that a currency is not measured on its own, like we would view a stock quote. For example, while I may say that Apple stock is currently trading at $369.80 or maybe IBM is trading for $182.39, we cannot do the same for currencies. Stating a stock quote gives us the amount of money it would take to purchase one share of company stock. Currency, however, is always quoted against another currency.

So, for example, it drives me absolutely nuts when I hear a major media pundit talk about the significant decline in the U.S. dollar. These rants are typically used to bash the U.S. government, with a nostalgic view of the fact that a dollar today just doesn’t go as far as it used to. While I understand the basis of the argument, the question that always must be asked after a dollar-bashing statement is, “Against what currency?” For example, is the dollar in a death spiral against the Zimbabwe dollar or Mexican peso? Of course not.

More often than not, the dollar is most commonly quoted against the euro, which has, in fact, been on a multi-year decline until recently. The reason for this common quote, or “pair,” as it is known in the investing world, is because the United States has the largest gross domestic product in the world, followed by the Euro Zone or Euro, which is a combination of countries such as Germany, Italy, Spain and Greece, all making headlines recently for their growing debt issues. Another topic for another day is the question of which would you prefer to own for the next several years knowing what is happening in Europe: the euro or the U.S. dollar? Again, we’ll revisit this later so file it away for another time.

Unlike a stock quote that can be reviewed against a company’s historical trading level to determine the general health of the company (for example, Eastman Kodak trading at $1.39 after reaching a 1997 high of $92.31 would be viewed as a very ill company), a currency quoted in relation to another currency can be used as a general way to determine the health of one country versus another. If one country’s currency has been rising against another, we could surmise that the economic health of the former is growing in relation to the other, and vice versa.

So at this point, one may ask, then what is the relationship of the U.S. dollar and the Chinese yuan? Well, interestingly enough, several years ago, the Chinese made the incredible and brilliant decision to fix their currency to the U.S. dollar. One U.S. dollar currently buys 6.3 yuan, however it is a ratio that has remained relatively fixed for quite some time, as they will move in relation to one another. Should the U.S. dollar decline against other currencies, such as the euro, so too will the yuan. It’s hard to believe the Chinese saw the writing on the wall with where the United States was headed and decided that, rather than allow their currency to gradually appreciate as their economy improved, they would hop a ride down with the U.S. dollar. But isn’t a declining currency a bad thing?

It’s at this point that currency movements can get very confusing, so I am going to use some generalized brush strokes to explain why currency values are so important, outside the normal “scorecard” of health. Currency fluctuation boils down to imports and exports and can be summarized through two arguments. If a country’s currency is stronger than another, it makes the stronger country’s goods less competitive within the second country. For example, if the United States dollar strengthened against the yuan (remember, this is not possible at present, due to being pegged), then U.S. goods would become less affordable to the Chinese in their country.

The other side of this is that foreign goods in our country would become more inexpensive for us. In addition, should the U.S. dollar rise, U.S. corporate profits would decline as money is brought back into the United States from foreign countries. Again, this can be very confusing, so don’t get caught up in the details here; focus on the big picture. The thing to remember is that as the U.S. dollar increases in value against another country, it makes our products more expensive in that country, while making that country’s products less expensive in the United States.

This is precisely President Obama’s argument and what I believe to be the most important piece of news going on at this very moment, as the U.S. Congress makes a decision on whether or not to pressure the Chinese to unpeg their yuan. The president’s argument is that by keeping the yuan artificially low, it is hindering our U.S. manufacturing and international sales. The president’s political opposition makes the argument that if the president is successful in urging the unpegged yuan, Chinese goods would be more expensive and thus hurt our economy even further. Based on what each side believes would happen to the Chinese yuan, if it were unpegged from the U.S. dollar, the economic principles make complete sense, however after spending time in the country and studying the situation, I believe them both to be wrong in their assumption as to the direction of the yuan should it no longer be fixed to the U.S. dollar.

China has economic problems and when you visit the country, these problems can be seen by the naked eye. Everywhere you look, in every major city, the casual spectator will notice miles of construction skyline. The buildings are amazing, as high-rise after high-rise is being built. However, they are all empty.

Everywhere you look, there is incredible construction that sits vacant, dark and downright creepy. In certain parts, it is not just empty buildings but entire cities, dubbed “Ghost Cities,” that go heavily unoccupied. Despite this strange phenomenon, builders keep building and high-rises keep rising. But why? If the demand is not there, why would a country continue to build and build?

Well, it’s really quite simple. The primary construction companies, which are all communist government-owned, are building to keep people working. They’re keeping people working to keep people fed. They’re keeping people fed so they can stay in power. It goes back to the original point, which we must not forget about China: it remains a communist country, and therefore has a central power source that has a vested interest in keeping its 1.3 billion people satisfied. One cannot forget that websites like Facebook are blocked by the government, and everywhere we went as American business tourists, we were treated with unbelievable courtesy, seeing all the best China has to offer. Yet under the surface, a trained eye can still recognized a model that is simply unsustainable.

The data points are mixed on Chinese growth, however these are Chinese-produced data points, which I will view with a skeptic eye. Since we cannot determine their currency “score,” the real measure of their health must be examined through the global price of raw materials they are in need of, such as steel, copper and oil, all of which have plummeted in recent months.

With such a slowdown in raw material prices indicating a lack of significant true demand, how is it possible then for the government to continue this massive subsidized jobs program, the equivalent of an ongoing U.S. stimulus package? It is my opinion that the Chinese government is printing money at a far more rapid pace than even the United States or Europe. If printing Chinese money can go undetected due to their currency being fixed to the United States, why would they not just keep on printing, paying and building as long as they can? My view is that China is simply printing the money to pay what it needs to in order to keep the Chinese population satisfied. As long as they keep the population satisfied, there will never be a hint of any revolution, as we have seen in other parts of the world within the last year. I believe that as long as the Chinese youth can keep enjoying their quasi-Western freedoms, there is no need for them to revolt, but the minute this is put into question, they could take to the streets, as others have in Libya, Egypt and Syria.

So how is all of this possible? Well, it’s possible because the world cannot measure the real health of the Chinese economy due to its currency being fixed to the U.S. dollar. The Chinese could print as much currency as they choose without it ever hitting the radar of the world. The only way we will know this is if the Chinese yuan is allowed to float on its own and receive a true grade from the world.

If my assumptions are correct, the idea that the yuan would strengthen against the United States once unpegged is vastly incorrect, and a floating yuan would plummet, thus revealing the true identity of the Communist agenda. The Chinese are printing at the expense of the United States and are holding us hostage with a fictitious belief that they have a strong economy and with the fear that a rising yuan would cripple our already unstable domestic economy. We all know that China owns trillions of dollars worth of U.S. debt. What if China simply printed money to buy this debt, and thus has made exorbitant investments in the United States under the guise of a strong economy, when in reality it is simply a strong printing press? This would truly be the ultimate Trojan horse and the most incredible method to “capture” our interests history has ever seen.

Late Friday night, I enjoyed a beverage in Shanghai’s Bund 18, overlooking the amazingly well-lit financial district. I watched young people of all walks of life enjoying a heavily Westernized experience. They danced to American music, enjoyed their alcohol and sent text messages to their friends from their iPhones. The energy was alive, and I could tell that this taste for real freedom was not going to go quietly into the night. I can’t help but wonder what will happen should the country not be able to keep the government employment going.

These youth will not go back to the way it was decades before. The only question is how long can the ploy continue? If the U.S. government doesn’t stand strong, pressuring the Chinese to unpeg their currency, it could go on for a very long time, at the continued expense of U.S. jobs and U.S. manufacturing.

There is no question the Chinese have increased their domination over the last several years, however now I know just how strategic they’ve been, and I’m downright amazed we’ve let it go on for so long.

U.S. minimum wage is currently $7.25 per hour, assuming 40 hours per week and 52 weeks per year.

Quint Tatro is the founder of Tatro Capital and the portfolio manager of the Tatro Capital Tactical Appreciation Fund. He is a frequent guest on CNBC and a contributor for Forbes.com, Minyanville.com, Financial Sense, and StockTwits.com.

 

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