Morningstar Advisor - December/January 2012 - (Page 50)

Spotlight From Currency Manipulation to International Acceptance By Michael Rawson While Congress labels China a “currency manipulator,” the U.S. dollar loses its luster. Despite its pre-eminence, the U.S. dollar and its role as the world’s reserve currency is threatened by unsustainable imbalances, particularly with China. Over the past year, the U.S. trade balance with China hit a record $289 billion deficit, up massively from $83 billion in 2001, the year that China entered the World Trade Organization. During this time, China accumulated $3 trillion in foreign exchange reserves. Instead of political grandstanding, the U.S. Congress should promote a better understanding of the economic constraints faced by our trading partners and a better appreciation for our responsibilities as the provider of the international reserve currency. In a free market, the Chinese renminbi would appreciate against the dollar, thus reducing the trade deficit. By pegging its currency to the dollar and purchasing vast quantities of dollar-denominated bonds to do so, however, China perpetuates this imbalance. During his confirmation process, U.S. Treasury Secretary Timothy Geithner stated that China was engaged in currency manipulation. Recently, the U.S. Senate passed the Currency Exchange Rate Oversight Reform Act, which essentially authorizes a trade war with China and labels it a “currency manipulator.” However, that pejorative term obscures the economic realities of foreign exchange and trade. The Role of Currency There are three functions that a useful currency performs. First, a currency serves as a unit of account, to keep track of asset values. Here, stability is key. Second, a currency must act as a medium of exchange. A currency is much more efficient than the barter system, which demands the double coincidence of wants. Third, a currency must be a good store of value. For example, if we save in dollars, we want our savings to maintain their value and not be eroded by inflation. To qualify for reserve currency status, not only must a currency incomparably meet the above three requirements, but it also must have a deep and liquid money and bond market. This is necessary so that foreigners have plenty of currency to facilitate transactions and to hold in reserves. Here it helps to be the world’s largest economy. Of course, in this regard, nothing comes close to the dollar. The ability of a government to issue currency at a price above the printing cost is an advantage called seignorage, which is only extended by reserve currency status. A currency can be thought of as an IOU or a short-term, non-interest-bearing loan that never gets redeemed. When a foreign nation buys dollars to hold them, it has to give up something in return. For example, it trades real goods or services for dollars, holds these dollars, and never redeems them for goods or services in return. While it is difficult to say what the value of this free lunch is for the United States, China holds nearly $2 trillion of U.S.-denominated securities (both government and private). The Trilemma Once two sides of a triangle are drawn, there is no uncertainty about the third. Similarly, the relationship between monetary policy, financial openness (constraints to foreign trade), and the exchange rate is a trilemma in which we can only control two of the three variables (Exhibit 1). Because international trade is such a small part of U.S. GDP and because it is the provider of the primary reserve currency, the United States shifts the burden of its exchange-rate policies to foreigners. This exorbitant privilege of the United States was laid bare by John Connally, the Treasury secretary under President Richard Nixon, who said that the dollar “is our currency but your problem.” For the United States, the advantage of being a reserve-currency nation has simplified the trilemma (also called the Mundellian impossible trinity after Nobel prize-winning economist Robert Mundell). The Federal Reserve is free to target interest rates without concern over spillover effects on the exchange rate. Viewed in this framework, 50 Morningstar Advisor December/January 2012

Table of Contents for the Digital Edition of Morningstar Advisor - December/January 2012

Morningstar Advisor - December/January 2012
Letter From the Editor
Seduced by Complexity
Is China Exposure Important for a Portfolio?
A Niche Built on Trust
How to Find Your Client’s Investment Style
Taking the Long View
Consensus on Europe Elusive
Four Picks for the Present
Investment Briefs
Is Perception Reality for Active Managers?
Be Alert for Basic-Materials Bargains
Investment Boom Unsustainable
Digging Moats in China
Where China’s Domestic Companies Stand to Benefit
Arising Opportunities
China Strong Long Term
From Currency Manipulation to International Acceptance
The Keys to China’s Fortune
Wedgewood’s Lessons Pay Off
Reading the Evidence on Indexing
Scouting for Investments Abroad
Yield, Please (Hold the Europe)
Mutual Fund Analyst Picks
50 Most Popular ETFs
Undervalued Stocks With Wide Moats
China Fund Managers Eat Elsewhere

Morningstar Advisor - December/January 2012