Fair Trade And China
Shore Line Times - December 30, 2004
Fair Trade and China
Patrick Smith, CFA
Shoreline Financial Advisors, LLC
Have you ever gone into one of the Christmas Tree Shops and tried to find something that was not made in China? It is possible, but it is not easy. Do you remember the mid-eighties when the dollar was so strong that it seemed as though there were more Americans in Europe than Europeans? In the late sixties/early seventies, it seemed that you could buy a Japanese car far more cheaply than the equivalent American car. Do these examples represent free trade or unfair trade?
In last week’s article, I wrote about the merits of free trade and how it has improved the wealth of our nation over the long run. The discussion was based on David Ricardo’s Law of Comparative Advantage. If you would like a refresher, that article, as well as some of our past articles, are available on our website, www.sfadvisors.com in the section titled “Reprinted Articles”.
Free trade only works when currencies are allowed to freely fluctuate in value. The distortions referred to in the first paragraph are a result of currencies being valued improperly. Since World War II, the ‘free world’ has migrated through several different currency regimes. Since Nixon severed our remaining ties to gold in 1971, the ‘free world’ has operated in a paper-backed system called a floating exchange rate system. In a pure floating exchange rate system, the market would determine the value of a country’s currency. This means that the US dollar should find an equilibrium with other currencies where the prices of similar products would be the same all around the world. The Swedish economist Gustav Cassel popularized this theory of Purchasing Power Parity, or PPP, in the early 1900s.
One of the conclusions of PPP is the value of a currency can appreciate over time if the output (goods and services produced) of a country increases more than other countries. Therefore, if a country experiences a large boost in productivity (output per person), then the country as a whole will experience a large boost to total output and its currency should appreciate.
So, what has this got to do with the price of tea in China?
China is not part of this exchange rate system. Its currency, the yuan, has had a fixed value relative to the US dollar for approximately ten years. During this time, the Chinese economy has grown at a rate of 9-10% while our country has grown at a rate of 3-4%. According to PPP, the Chinese yuan should appreciate considerably against the dollar. Therefore, China is unfairly benefiting from an undervalued currency. This is why Chinese goods are so inexpensive. This is why the current administration is calling for China to allow its currency to ‘float’. This is why products ‘Made in China’ may get a bit more expensive in the future. And finally, this is why investments in Asia, that include China, may do well if the yuan is allowed to float. Remember, investments in foreign countries carry additional risks.
There is a fine line between free trade and fair trade. The continued globalization of the world’s economies and the subsequent increase in trade has helped many impoverished nations build wealth. This helps developed nations through a reduced demand for aid. Our nation should continue to press for free and fair trade.
Patrick Smith is a partner at Shoreline Financial Advisors, LLC in Guilford. He was formerly a Senior Vice President and portfolio manager at Pioneer Investments. He earned a BBA from the University of Notre Dame and an MS in Finance from Boston College. He is a Chartered Financial Analyst.
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