Is China in a currency war with U.S.?

China’s recent surprise decision to devalue its currency, the renminbi (also known as the yuan), versus the dollar sent shock waves through financial markets. It could trigger a race to the bottom to gain an export price advantage, which would have a major impact on the U.S. economy and on looming decisions by the Federal Reserve.

Many believe China’s move was an effort to gain a trade advantage. A drop in the yuan’s value makes Chinese products cheaper, costing thousands of jobs by forcing factories outside China to close.

China said the devaluation was a one-off event, but the move could set off a currency war, which is when two or more countries engage in currency devaluations to improve the competitiveness of their products in global markets.

Over 35 years, China has developed from abject poverty into an economic giant. It is the world’s second largest economy and accounts for about 12 percent of global exports. A country so reliant on trade must maintain the growth of exports, which have been the most important driver of China’s growth since liberalizing its economy in 1978. The U.S. is their biggest customer.

Chinese farmers continuously leave the countryside for higher paying jobs in urban areas. Robust economic growth is needed to absorb this workforce and maintain social stability and the existing political order, which is a top priority. If the economy worsens, China may further devaluate its currency to export its way out of the decline. Chinese exports were down 8.3 percent in July compared to 2014.

More importantly, China’s economic growth has slowed to an annual rate of 7 percent. That’s healthy for most countries- the U.S. struggles to keep annual gross domestic product growth above 2 percentĀ­ but far below the previous decade’s double-digit growth.

Even though its GDP remains smaller than that of the United States, China is the world’s largest trading nation and is many countries’ most important bilateral trade partner. In the future, the yuan may well eclipse the dollar as the preferred currency of trade.

Some believe the devaluation may cause other countries’ central banks to respond, triggering a currency war. Both Japan and the European Union have repeatedly depressed their currencies in the past two years to promote exports. The U.S. certainly does it. The dollar took a deep dive after the Federal Reserve cut interest rates to near zero and flooded the world with cheap money through its quantitative easing initiative.

The devaluation engineered by Beijing also complicates the Federal Reserve’s September decision about whether to raise interest rates, which have been near zero since the 2008 financial meltdown. A weaker yuan would reduce the price of Chinese goods in the U.S. This would further depress the 1.3 percent inflation rate, which is below the Fed’s target of 2 percent.

Last month, the U.S. government reported that the economy added 215,000 jobs and the headline unemployment rate remained at a low 5.3 percent. That could support a Fed decision to raise its key interest rate.

But low inflation, weak increases in hourly wages and continued low labor-force participation could be reasons to delay their planned 0.25 percent increase until early next year. A rate hike would increase the dollar’s value, which would cause even more angst for American exporters, kill manufacturing jobs and sales of American goods; and slow economic growth.

To further complicate the situation, China has stockpiled more than $1.2 trillion in U.S. bonds, which help finance wars and huge budget and trade deficits. If foreign countries stop buying treasury bonds, rising debt would mean higher interest rates because investors would insist on higher returns.

The bottom line is that while there are a number of incentives for countries to devalue their currencies, every effort should be made to avoid the kind of competitive devaluations that exacerbated the Great Depression in the 1930s.

Originally Published: August 22, 2015

Oligopolies – and your wallet

The term “oligopoly” used to be a negative term to most people, just as “competition” had a positive connotation. Oligopolies occupy the middle ground between monopoly and the idealized world in which numerous firms compete.

An oligopoly is an industry in which a few firms dominate and exercise considerable stroke over consumers and suppliers. The goal of making those firms as profitable as possible is not served by facing off in never-ending cutthroat competition.

But what’s best for companies is not necessarily good for consumers. In an era of rampant consolidation, intelligent regulation is needed to promote competition.

Businesses work hard to insulate themselves from the “invisible hand” of the free market. The few firms in an oligopolistic industry are in the enviable position of setting prices, whether through collusion or silent agreement. The tendency is to cooperate with each other to minimize rivalry so as to maintain a common front against buyers and sellers, and create market power in certain geographic markets, or among particular consumer groups or product lines, which can lead to higher consumer prices and inferior service.

From the consumer’s perspective, oligopolies aren’t much different than a monopoly, where one firm has a stranglehold on a product or service for which there is no alternative. Moreover, oligopolies usually throw their weight around by exerting pricing power over suppliers.

There are oligopolies throughout the global marketplace, and concentration and consolidation appear to be increasing in U.S. industries from cable television, pharmaceuticals and airlines to banking and health insurers. As they concentrate further, profitability increases and consumers are disadvantaged. Left unregulated, these firms have enormous power to strategically restructure their industries and impose very high prices on consumers.

The airline industry is a prime example of an oligopoly, with 80 percent of all domestic passenger travel dominated by just four carriers. A wave of consolidation has been sweeping the U.S. airline industry: American Airlines merged with US Airways, United merged with Continental and Delta with  Northwest. Southwest acquired AirTran.

Consumers appear to be paying the price for this consolidation with fares and fees rising faster than inflation, and one or two airlines dominating particular markets. On June 30, the Justice Department announced it is investigating whether U.S. airlines have worked together to keep airfares high by limiting the number of flights and seats.

Another example is the banking industry. Despite reforms in the wake of the “Too Big to Fail” public bailouts, the five biggest U.S. banks now control nearly half the industry’s $15 trillion in assets. In 1991 the five largest banks controlled just 10 percent of industry assets. The concentration suggests that banking is not a competitive industry and it allows banks to jack up fees.

Health insurance is the most recent example. Over the last several weeks, Anthem reached an agreement to purchase Cigna and Aetna agreed to buy Humana. These two proposed deals reduce the number of for-profit health insurers to three.

But the bottom line is that these waves of consolidation hurt consumers by reducing competition. To change that, the “visible hand” of intelligent regulation needs to operate along with the invisible hand of market forces to promote competition and protect consumers.

Originally Published: August 15, 2015

China’s power over US interest rates

While the Greek debt crisis and the Iran nuclear deal are all the buzz in the media, you may have noticed a major selloff on the Shanghai Stock Exchange over the last several weeks. There are global implications when the stock market of the world’s second largest economy is out of control, and the impact could be felt right here in the U.S.

China is a country of superlatives. Its population of more than 1.3 billion is larger than that of any other country. Its foreign reserves are about $4 trillion. The Chinese government owns $1.27 trillion in United States bonds.

As recently as the early 1990s, China was a minnow on the global trading stage, now it is the world’s largest exporter. It has helped lift hundreds of millions of citizens out of poverty and its per capita GDP has more than tripled since 1980.

Now that China has established itself as an economic powerhouse fueled by rapid growth, its foreign policy is becoming increasingly aggressive. It is asserting territorial claims over much ofthe South China Sea and their cyber-attacks on both business and government networks in the United States are creating a potential bipolar global rivalry with America just as the Cold War with the Soviet Union did.

China has evolved a system of state capitalism since the government began to introduce some market forces into the economy in the late 1970s. But the government is still the dominant economic actor despite all of President Xi Jinping’s rosy rhetoric about allowing markets forces to play a decisive role in allocating key resources and investment decisions.

The last two months have felt like a rollercoaster for the estimated 90 million retail investors in the Chinese stock market. With the government hoping companies would raise capital in the stock exchanges rather than seeking bank loans, novice investors bought stocks on margin with huge amounts of borrowed money, helping to create a stock bubble and runaway bull market.

Over the last several weeks the Shanghai Stock Exchange was down 30 percent. While no single factor appeared to spark the selloff, analysts attribute it to fear of slowing economic growth and the worldwide slowdown in demand for Chinese exports.

Fearing the slide might cause the economy to fall off a cliff, it was met with heavy-handed intervention by Beijing. The government cut interest rates, suspended trading for 1,400 companies, banned short sales, prohibited major shareholders from selling shares to stop the selling stampede and halted new initial public offerings.

The United States had better hope China doesn’t decide to bail out its stock market and stimulate its economy by starting to cash in some of its United States bond holdings. If that happens, U.S. interest rates will rise whether the Federal Reserve likes it or not. Of course, Japan and OPEC may step up and buy the U.S. debt if interest rates rise and U.S. bonds become more attractive.

The Chinese government’s tight control of the stock markets is not exactly consistent with allowing market forces to allocate financial resources. It’s unclear whether a government-dominated economy can have a free stock market.

International Monetary Fund chief Christine Lagarde recently said that, “China is still learning how stock markets work.” And that learning curve could have a big impact here on the other side of the world.

Originally Published: August 8, 2015

America’s own Greece- Puerto Rico

While much attention has been focused on the Greek drama, out-of-control debt is rearing its ugly head closer to home. The small island of Puerto Rico is in a bad way; the lyrics may be different but the melody is the same.

The governor of Puerto Rico dropped the bombshell last month that there is no way the island can pay its $72 billion in public debt. He pledged to begin developing a debt restructuring plan.

Since the financial meltdown of 2008, debt is like a canker spreading across the globe. The Greek analogy may be overused, but in one respect it is relevant. Greece and Puerto Rico are among many governments with too much debt and not enough economic growth to generate the tax revenues needed to cover it.

Short of a federal bailout, the island will be unable to repay its debt between now and the Second Coming. To paraphrase Margaret Thatcher: “Puerto Rico has run out of other people’s money”.

Puerto Rico is by far the most indebted American territory or state, owing $20,400 per capita. Since 2005, the island’s economy has shrunk by about 10 percent. Its unemployment rate is above 12 percent; more than double the national average. Since government benefits are more lucrative than a minimum wage job, just 40 percent of the adult population is working or looking for work. The U.S. labor participation rate is 63 percent.

Moreover, high labor costs have proven onerous for many businesses. Generous overtime provisions, excessive paid vacation benefits and job security regulations that are more costly than on the mainland all magnify employment costs and kill the demand for labor. The island’s population has also declined from 3.8 to 3.5 million since 2005 as Puerto Ricans leave for Florida and other parts of the U.S.

Until 2006, Puerto Rico’s economy was kept afloat by tax incentives for American pharmaceutical, textile, electronic and other firms that manufactured there. When the tax breaks disappeared in 2006, it contributed to the loss of 80,000 jobs. Puerto Rico’s economy has been in free fall ever since. The weak economy drives the middle class to the U.S., the shrinking population results in a smaller tax base and the beat goes on.

Puerto Rico’s bonds, unlike those of states or municipalities, are exempt from federal, state, or municipal taxes everywhere in the United States. Thanks to this competitive advantage, they were quite attractive to bond funds and investors in the highest tax brackets. More than 180 municipal bond funds have at least 5 percent of their portfolios in Puerto Rican bonds. Many hedge funds and distressed debt buyers stepped in to buy Puerto Rico’s bonds at deep discounts as the island’s economy worsened and its credit rating dropped below investment grade in early 2014.

Unlike municipalities, states and Puerto Rico are barred from seeking bankruptcy protection. The Governor has appealed to Washington to change the law so the island can seek bankruptcy protection, buy time to restructure debts and get its fiscal house in order.

Chapter 9 of the bankruptcy code allows a company or municipality to get new financing from markets while continuing to function as debts are restructured or written down. The importance of orderly debt restructuring was in evidence during the recent bankruptcy process that helped Detroit to restructure its $18 billion in debt.

Without allowing Puerto Rico access to the partial remedy of bankruptcy, the island has no chance of pulling out of its death spiral. Like Greece, Puerto Rico is stuck in a vicious cycle and badly needs structural reforms to set the economy on a sustainable path. The challenge is to grow the economy while at the same time fixing its public finances.

There is one lesson to be learned from Greece: Expect Puerto Rico’s fiscal crisis to get worse if debt restructuring and the implementation of reforms to make the island economically competitive are delayed.

Originally Published: August 1, 2015