© 2015 Prof. Farok J. Contractor, Rutgers University
Janet Yellen Agonistes
Bah! Humbug! What can a mere quarter-percent hike in the Federal Reserve Bank’s interest rate do to markets? It seems so small a change as to be trivial.
For two years prior to Janet Yellen’s appointment as Chair in January 2014, her predecessor, Ben Bernanke, and the business press speculated on the timing of a rate hike with casuistic verbal contortions that kept the markets guessing. Finally, the agony was over on December 16, 2015. After almost a decade, the Fed raised short-term interest rates by . . . a mere one-quarter percent.
But what was the agony all about? The millions of words in the media, the roiling of markets worldwide?
A Multiplier Effect on Bond and Exchange Markets
Even a one-quarter percent increase can have a much larger impact on bond markets and foreign exchange rates. The math examples below abstract from many other market considerations, including the time value of money, the length of the bond when the principal amount would be returned, and forward exchange rates, but will suffice to explain the multiplier effect in simple terms.
BOND MARKET EXAMPLE
Imagine that Investor A owned, prior to December 2015, a bond yielding 1.5% and that a new Investor B purchased, after December 2015, a bond yielding 1.75%:
Investor A: Before December 2015, a $10,000 deposit would have been yielding the owner 10,000 (.015) = $150 per year in interest.
Investor B: After December 2015, with a quarter-percent interest rate increase, a new investment of $10,000 would yield $10,000 (.0175) = $175 per year.
With bonds being traded in the market, which now expects a 1.75% return (as against the old 1.5% return), Investor A’s bond could now lose value by up to $1,250. This is because after December 2015, an investment of only $8,571 would yield 8,571 (.0175) = $150 in interest per year.
The face value of Investor A’s investment of $10,000 would therefore be devalued in the bond market (by other new or later investors like Investor B, who are now targeting a 1.75% return) to as low as $8,571.
Hence a mere one-quarter percent interest rate jump could devalue a bond by as much as 14 percent: (10,000 – 8,571)/10,000 = 0.1429, or a drop of up to 14.3 percent in face or resale value.
EXCHANGE MARKET EXAMPLE
Imagine that Frenchman Pierre had invested, prior to December 2015, in US bonds. Assume for simplicity’s sake that the exchange rate prior to December 2015 was €1 = $1.10.
Before December 2015: A €10,000 investment by Monsieur Pierre would have converted into dollars 10,000 (1.10) = $11,000, which Pierre used to purchase US bonds yielding 1.5 percent annually (this return compares favorably with similar-grade investments in Europe):
[11.000 (.015)] = $165 in interest annually.
$165 converted back into euros would yield 165/1.10 = €150 . . . or an expected 1.5% yield for investor Pierre.
After December 2015: If exchange rates remained the same, Investor Pierre would continue to receive the same $165, or €150—a 1.5% rate of return in interest.
However, many other new investors, such as Monsieur Quentin, could earn a 1.75% return after December 2015 if the exchange rate did not change and remained at €1 = $1.10:
An investment of €10,000 (1.10) = $ 11,000.
$11,000 (0.0175) = $192.50 in interest.
$192.50 converts back into 192.50/1.10 = €175, assuming exchange rates do not change.
HOWEVER . . .
Seeing the higher returns available after December 2015, yet other French investors, such as Monsieur Raymond, and a great many many others, would be eager to participate in the game. As a first step, in order to invest in the US bond market, euros have to be sold (supplied to the exchange market) and dollars purchased (or demanded in the foreign exchange market). Foreigners cannot invest in US dollar instruments unless they first exchange their own money for the US dollar in the foreign exchange market. This collective extra demand for the US dollar, from a host of foreign investors, would drive up its exchange rate. Recall that the world has a trillion dollars equivalent, or more, in liquid assets looking for a higher return. Billions of euros are ready to be sold and dollars demanded, each day, if the prospect of a higher return exists. Collective higher demand for any free-floating currency such as the US dollar can drive up its value in milliseconds or minutes, from €1 = $1.10 to say €1 = $1.0209. (This 1.0209 new exchange rate is only an example—one among many scenarios of a stronger dollar.)
Hence, after the dollar strengthens in the exchange market:
An investment of €10,000 (1.0209) = $10,209 from the currency conversion at the new exchange rate.
$10,209 (0.0175) = $178.66 in interest earned.
Assuming the dollar remains at the appreciated (stronger) exchange rate, $178.66 converts back into 178.66/1.0209 = €175, which is the same targeted €175—but now illustrated with a devalued euro or a strengthened or appreciated US dollar.
The euro can then have devalued from $1.1000 to $1.0209, or more than seven percent. A mere one-quarter percent hike in US interest rates can cause the euro to devalue by seven percent, as an example.
Simple Math Examples Obscure Many Complications—But Still Reflect Basic Facts
Actually, many other considerations and motivations influence investors in bond and exchange markets. For instance, the euro could devalue even more than the seven percent illustrated above if French or European investors are content to earn less than 1.75%. After all, recall that Monsieur Pierre was content to accept a return of only 1.5% prior to December 2015. What the simple examples above do not incorporate is the fact that a devalued euro also potentially changes (for the European investor) the re-conversion of the principal invested into euros, on the maturity of the bond, and not just the interest earned on the bond. For that we would need to do more complicated math involving the time value of money.
Nevertheless, the above simple examples do illustrate how a mere one-quarter percent interest rate hike by the US Federal Reserve Bank can cause much larger swings in the bond and foreign exchange markets. How important is the dollar-euro exchange rate? In 2014, US–EU trade (imports + exports in goods and services) exceeded $800 billion. Transatlantic investments amounted to hundreds of billions more. To say that the international business relationship between the US and the EU is enormous is a gross understatement. Similarly, the US’ business with China and other countries is also directly affected by the strength or weakness of the dollar.
Small shocks or changes in US interest rates ripple outward to the rest of the world. Janet Yellen and her colleagues were right in agonizing so long and hard.
 This is an over-simplified example because it does not incorporate the principal on maturity and the time value of money. However, it serves to make the point that a tiny change in interest rate expectations can make a large difference in the value of the bond.
 See my September 11, 2015 post Capital Outflows from China and the Hidden Story in China’s FDI Statistics.
 US Census Bureau. Trade in Goods with European Union.
© 2015 Prof. Farok J. Contractor, Rutgers University
November 30, 2015 was a red-letter day for China—and for Zhou Xiaochuan, governor of China’s central bank.
Governor of the People’s Bank of China (China’s central bank) since 2002 and a cautious and methodical bureaucrat, Zhou is the essence of his country’s Mandarin class: canny and understated, but relentless in his objective to elevate China’s economy and currency to elite status. Under Zhou’s watch, China’s exports to the rest of the world almost quintupled (see Figure 1), and in 2015 China is the world’s largest exporter, with 13 percent of the global total. If one takes the World Bank’s purchasing power parity (PPP) exchange rate, the size of the Chinese GDP in 2015 is neck-and-neck with that of the US. (See my January 2, 2015 post Is China set to become the world’s largest economy in 2015? This post was also published at Rutgers Business Insights.)
Figure 1: China’s Exports to the Rest of the World (2004–2014)
And yet, few governments or institutions have been willing to hold the yuan (or renminbi yuan [RMB]) as an asset. RMB holdings comprise only around 1 or 2 percent of the rest of the world’s reserve total. Nearly two-thirds of world government reserves (see Figure 2) are still held in US dollars—because of historical habit and because most international transactions continue to be denominated in dollars (gold, as a reserve asset, has a negligible part).
Figure 2: The US Dollar Still Dominates
Source: Michael Lingenheld. Forget the Military, America’s Greatest Weapon Is the Dollar. Forbes, March 13, 2015
What is a reserve currency and what functions does it perform?
Imagine that an Indian exporter has shipped goods to Malaysia and has been paid in US dollars. Being an Indian company, it turns over the earned dollars to a bank in India in exchange for rupees. The Indian bank, in turn, hands the dollars over to India’s central bank, again in exchange for rupees. The dollars end up being held by the Indian central bank, the Reserve Bank of India, as an official reserve asset.
Imagine then that an Indian importer wishes to import an item from China, payable in US dollars (assuming that most suppliers outside India are loath to accept rupees). The would-be importer goes to a bank with rupees and asks for dollars, which the bank supplies to the importer from the Indian central bank reserves.
A country’s central bank reserve acts like a storage tank. As long as the dollar supply into the tank (from dollar earnings of exporters, remittances, foreign investment, etc.) is equal to or greater than the country’s demand for dollars from the tank (from importers or persons wishing to remit money abroad), the storage tank (reserve) will not go dry. The reserve acts like a buffer against fluctuations in imports and exports.
But a government’s reserve also can perform another function. If confidence in a country’s currency declines, and a sell-off of the currency occurs in the foreign exchange market, the currency’s exchange rate can devalue. Let’s say the Chinese government wishes to counter devaluationary forces and stabilize its currency. One method it can employ is simply to buy RMBs massively in the foreign exchange market. Increased demand for the RMB would prevent its devaluation and stabilize its value. But if the Chinese government buys RMBs in the foreign exchange market, it has to offer the seller something in return. What?
The answer is, for example, dollars from the Chinese government’s previously accumulated dollar reserves. This is exactly what occurred in mid-2015, when the RMB began to fall or devalue from 6.2 RMB/$ to 6.4 RMB/$. The Chinese government spent several hundred billion dollars out of its ($3–4 trillion dollar) reserves in order to stabilize the RMB and prevent it from falling further.
By the same token, if a government considers that its currency is getting “too strong” and wishes to devalue it, or prevent it from appreciating further, it could buy (demand) dollars in the foreign exchange market, offering the counterparties in the market its own currency. The extra supply of the country’s currency could prevent its further appreciation. The dollars the government buys end up increasing its official dollar reserves. (Also see my November 16, 2015 post Is China a “currency manipulator”? Donald Trump says so.)
What is the role of the IMF?
Until November 2015, the RMB comprised hardly 1 or 2 percent of other countries’ official reserves. Despite China’s position as the world’s biggest exporter, even Chinese imports and export orders are largely denominated in other currencies (such as dollars or euros). With the yuan being a controlled and not easily convertible currency, firms and governments outside China are reluctant to hold RMBs.
Zhou Xiaochuan and his government have been chafing and quietly lobbying to change that. Given China’s leading role in trade and in world economic rankings, to them it is humiliating to see the RMB have so tiny a holding outside China. If one counts both private as well as government (international, or non-local) assets, the dollar easily exceeds three-quarters of the value of non-local assets, compared with around 1–2 percent for the RMB.
The IMF is a mutual-assistance club of 188 country members. Its original principal purpose was, and remains, to help nations encountering a balance-of-payments crisis. Consider a hypothetical IMF member country in 2008—let’s call it Fredonia. Because of the global recession, between 2008 and 2012 Fredonia’s exports to the rest of the world fell sharply, and the dollars earned by Fredonia’s exporters fell by 30 percent. (This actually happened to many nations during the recession.) But Fredonia’s imports are essential items—energy, food, medicines, etc.—that could not be cut without hurting its population. And these commodities have to be paid for in dollars. (No one outside Fredonia is willing to accept “Fredos”— they insist that importers pay them in dollars).
So how does a nation like Fredonia continue to import vitally needed commodities if, on the export side, its exporters’ dollar earnings have fallen by 30 percent? It turns to the IMF (International Monetary Fund) for help.
The IMF helps nations facing a currency crisis to get dollar or other “hard currency” loans from other countries that have accumulated dollar reserves. The IMF thus acts as a friendly loan broker between nations and as a facilitator to tide over those countries suffering significant balance-of-payments deficits.
However, since 1970, the official government reserves of all 188 IMF members have grown much slower than world liquidity has. Put simply, growth in international transactions (trade or “imports + exports,” cross-border portfolio and direct investment, and private remittances) has been vastly greater than the growth of all countries’ national reserves. And recall our earlier discussion—that a country’s reserves are supposed to act like a buffer against shocks or shortfalls in foreign currency earnings. The typical nation’s buffer (or reserve) has not grown as fast as its international transaction volume, which can be a danger.
To alleviate this danger, the IMF created from scratch, or out of nothing (i.e., in its computers), a notional reserve currency called the SDR (Special Drawing Right), which it then divided and allocated to its member countries. The SDR is not a usable currency, and it does not exist anywhere except in the IMF’s computers and as a notional asset in member countries’ central bank computers. But it adds to each country’s buffer reserve and can be used in a balance-of-payments crisis.
In the example of Fredonia, during the period 2008–2012 when that country’s export (dollar) earnings fell way below its need for dollars to continue necessary imports, it could use the SDRs previously allocated to it by the IMF. Relinquishing its SDRs to the IMF, the IMF would then find another nation with surplus dollars in its reserves and ask that nation to temporarily (for a few years) swap SDRs for dollars with Fredonia. That way, Fredonia’s central bank would receive actual dollars that it could use to continue importing items critically necessary for its populace, augmenting the dollars earned by its exporters.
What’s the big deal about including the Chinese RMB in the SDR?
The SDR, a notional currency, is usable only in exchanges between central banks. Nevertheless, to effect the inter-governmental exchanges, the SDR has to have a formula to calculate its value. After 1999, with the introduction of the euro, the IMF decided that the euro would be allocated a 37.4 percent share or weight in the SDR, the dollar a 41.9 percent weight, the Japanese yen 9.4 percent, and the UK pound 11.3 percent—roughly reflecting these major countries’ role in global commerce at that time. But by 2015, China had muscled in and earned its status as a dominant player in international business, and the RMB or yuan could not be ignored, despite it puny role in international transactions and despite its being a not-easily-convertible currency.
After a debate of several years, and with steady pressure from Beijing, the IMF announced on November 30, 2015 that the yuan would be allocated a 10.92 percent share or weight in the formula for the SDR (see Figure 3). It is worth noting that the Chinese share comes at the expense of reduced shares for the euro, yen, and pound—but not at the expense of the US dollar, whose share and role in international business remains unchanged and paramount.
Figure 3: The Formula for the SDR
Is this a great victory for China—or mere symbolism?
Among the Chinese elites that run that nation, and among its increasingly assertive middle classes, nationalism and historical memories run deep. Five hundred years ago, China was the world’s biggest economy, and the humiliation of being overtaken and later suppressed by Japan and the West between 1895 and 1949 still rankles. Any recognition of China’s status in 2015 is appreciated and met with great pride by its people. Indeed, today it is the world’s biggest exporter and (on PPP exchange rate terms) an economy more or less the same size as that of the US. Yet, being allocated a 10.92 percent share in the SDR formula is at present a mostly symbolic triumph, since the SDR is not a real currency. However, it can lead to real changes over the coming decade.
Even with additional SDRs being “created” in IMF computers, the fact is that SDRs amount to a mere $285 billion and comprise only around 5 percent by value of all governments’ central reserves. Moreover, all government reserves amount to a mere $6 trillion equivalent, which, in this author’s opinion, is a dangerously low amount given the huge liquidity in global commerce today. Liquid assets worldwide easily exceed $100 trillion, and daily turnover in foreign exchange markets worldwide exceeds $5 trillion. With only $6 trillion in total world reserves, the ability of governments to fight determined panics and capital flight is today dangerously inadequate. (See my September 10, 2015 YaleGlobal article Seeking Safety Abroad: The Hidden Story in China’s FDI Statistics).
It is therefore likely that the IMF will greatly increase its creation and allocation of SDR reserves to governments in the future. That, together with China’s eminent role, its assertiveness, and its continuing push to have other governments hold and trade RMBs, is very likely to expand the yuan’s role in the years ahead.
Even outside the IMF framework, China has been pushing bilateral swap deals worth 3 trillion yuan with more than 20 nations. For example, in 2013 the Chinese central bank swapped the equivalent of $30 billion worth of yuan for Brazilian real. This increased both countries’ official reserve position, but also provided encouragement to their importers and exporters to stop invoicing in dollars and use each other’s currencies instead. Trading in the RMB has significantly expanded since 2010 to seven offshore locations (see Figure 4), with transactions multiplying 23-fold by 2014 (albeit from a very small base).
Figure 4: Offshore Trading Centers for the Yuan
Original Source: Standard Chartered
Final Thoughts: Zhou’s story is China’s story
Zhou Xiaochuan’s journey has been a remarkable one, from being ordered to work at a farm for four years during the cultural revolution (1968–1972), to being rehabilitated and earning a PhD in 1985 from Tsinghua University in Economic Systems Engineering, and to serving as central bank head for 13 years continuously under three presidential regimes—those of Jiang Zemin, Hu Jintao, and Xi Jinping.
Zhou’s story is also China’s story. A poor, developing nation in 1968 under the dictate of a centrally planned leadership, market forces—even partially unleashed under Deng Xiaoping—have wrought one of the most remarkable transformations in human history, whereby 800 million persons have had their lives lifted from a hardscrabble existence into a tolerable or comfortable middle-class life. And the number of billionaires in China now surpasses the number in the US.
 RMB internationalisation will benefit from stronger transatlantic, transpacific coordination. Standard Chartered Bank, June 22, 2015.
 A bank in India would typically hold some of its own dollars for daily use, but the supply of dollars to an Indian bank comes from the Indian central bank, which in turn receives dollars from the export earnings of Indian firms, remittances, and other external sources.
 See China now has more billionaires than U.S. CNN Money, October 15, 2015. However, according to Robert Frank, Countries with the most millionaires. CNBC Inside Wealth, October 13, 2015, the numbers of millionaires in the US—15.7 million—greatly outnumber those in China, at only 1.3 million (at least according to official data). That is to say, if you are a billionaire in China, it is difficult to conceal your wealth; but a mere millionaire in China can lie low, under the radar of official statistics.
© 2015 Prof. Farok J. Contractor, Rutgers University
See the updated post: Second Helping, November 24, 2016
As Americans sit down to their Thanksgiving Day repasts each year, they are taught to recall the story of the “Pilgrim Fathers,” who in 1620 founded one of the first English settlements in North America at what was then Plimoth Colony in the State of Massachusetts. But the story of the English settlers seeking religious freedom in the New World was not, initially, one of gratitude. On arriving, they found nothing but “. . . a hideous & desolate wilderness, full of wilde beasts and wilde men.” It was almost as if the settlers had landed on an unexplored frontier, like the Americans landing on a pristine moon more than three centuries later.
Early Globalization and the New World
See More at Plimouth Plantation
In fact, the very survival of Plimoth Colony, which evolved into the town of Plymouth, as well as the turkey that sits on the center of American tables on the fourth Thursday of each November, are testaments to more than a prior century’s globalization and trans-Atlantic travel. After 1492, when Cristoforo Colombo (re)discovered the Americas (the Norse had already settled in Canada around the year 1,000 under Lief Erikson), the Spanish and Portuguese had crossed the Atlantic thousands of times before the English settlers arrived in 1620; but they had concentrated mainly on the warmer and more fertile colonies in Mexico and Latin America. The English were left with the frigid, seemingly inhospitable remains—the North American forests, which appeared to have little economic value.
Most Americans at their Thanksgiving Day table do not realize that the large bird they are consuming is not native to America . . . and certainly not to Turkey. Its origin is Mexico, descended from a fowl that the Spanish exported to Europe a century before the English colony in the New World was established. By 1530, this bird could be found abundantly in European and British farms. However, in Europe it was confused with the guinea hen (an African fowl) that had previously been imported into Europe via Ottoman Turkey. Apparently, the taste, and the economics, of the Mexican bird were superior, and thus it displaced the African bird from European farms and tables. It is most likely that what Americans know today as the turkey is the Mexican bird, consumed by Europeans and then later re-imported back to North America on English ships. The Plimoth Colony settlers did hunt fowl, but if their catch included turkeys, it was the North American wild turkey (Meleagris Americana), not the Southern Mexican variety (Meleagris Mexicana) that evolved into today’s turkey. (Of course, today’s factory turkey is so genetically modified from its Mexican original that it is bland and likely much more tasteless, a far cry from its Mexican progenitor.)
“Squanto” and the Survival of Plimoth Colony
Nine months after their arrival, more than half of the 102 individuals that disembarked from the Mayflower had perished of hunger and disease. The utterly unprepared and amateurish Pilgrims had arrived too late in the autumn of 1620 to plant crops, had underestimated the severity of the New England winter, and, to their surprise, found that their landing spot near the Cape Cod peninsula was unpopulated—so no human help or local advice was available. In another example of the effects of globalization, the Native American population in the area had been wiped out just a few years earlier through small pox and other diseases introduced by previously arriving English trading ships. One of these earlier ships in 1608 had sweetly proposed to exchange English metal goods for beaver and other animal skins, but then had captured and enslaved some of the natives and transported them to Europe.
One of them was a young man of the Patuxet tribe named Tisquantum (later shortened to Squanto), who was sold as a slave to Spanish Catholic priests for £20. Freed in 1612, Squanto traveled to England and lived in London for six years, with what must have been a wild hope of returning to his native village. In fact, it was not so improbable an aspiration because globalization was by then well established. Each year English trading ships would travel to New England to trade, pillage, and enslave. In 1618, Squanto’s English-language abilities and general acumen were noticed by an English ship captain who offered to take him back to New England in return for his translation and intermediary skills. Landing somewhere near the State of Maine, it took Squanto three years to walk his way south and find his native village (the place called Plimoth by the Pilgrims).
In the spring of 1621, as despair and death faced the weakened remaining English settlers, to their utter amazement a Native American speaking English, as well as the area’s Wampanoag language, stepped into their settlement, offering them friendship, advice on what crops to plant, and how to hunt and trap animals. More importantly, Squanto served as an ambassador or bridge to the area’s Narragansett and Wampanoag Indians, so that for a remarkable half century there was an uneasy peace between the English and the natives.
But by 1675, with more than 22,000 English immigrants, the natives realized they were being displaced from their own lands, and they launched an attack under the leadership of Metacom. This is sometimes described as the First Indian War. Of course, the locals were no match for English guns and growing numbers of colonists. The English presence in North America was by now an unassailable presence, whose later growth would populate the continent from “sea to shining sea.”
Conclusion: Thanksgiving Is as Much a Globalization Story as It Is an American One
Americans who enjoy their Thanksgiving repast are mostly oblivious of the fact that the story of the very founding of the United States is very much a story of globalization. Squanto’s trans-Atlantic journeys, his role in enabling the English bridgehead on the American continent, and the export and re-importation of the Mexican bird known to us as the turkey are vivid examples that globalization was commonplace—and even routine—by the 17th century.
 From the diary of William Bradford (1590 – 1657), Governor of Plymouth Plantation Colony, Cape Cod, 1620: “A Hideous and Desolate Wilderness.” In History of Plymouth Plantation. In 1621, when only 50-odd half-starved survivors were left of the 102 that disembarked from the Mayflower, the word “governor” may have sounded far too grandiose a term. But with new annual arrivals, despite losses, the number of English grew to 180 by 1624, and had increased to over 1500 by 1650. (Patricia Scott Deetz and James Deetz, Population of Plymouth Town, Colony & County, 1620-1690.)
 John Bemelmans Marciano. On the origin of the species: Where did today’s bird come from? The answer may surprise you. Los Angeles Times, November 25, 2010.
© 2015 Prof. Farok J. Contractor, Rutgers University
After 20 years, the Chinese government must be used to it—being bashed by US politicians and Congress as a “currency manipulator.” Indeed, the exchange value of the yuan (or renminbi [RMB]) is fixed each morning by its central bank, the People’s Bank of China (PBoC), with a narrow band of only + 2 percent allowed, up or down, within which market forces can have their say. In effect, it is an exchange rate set and controlled by the PBoC.
But why pick on just China?
Most countries “manipulate” their exchange rates…
According to the IMF (International Monetary Fund), well over half its member countries’ governments meddle, in a mild or total fashion, to influence or fix their exchange rates. As shown in Figure 1, “Fixed Peg” and “Currency Board” are countries with currency values fixed for a considerable period of months or years. In “Managed Float” cases, market forces are allowed to play, but with the government intervening (buying or selling) to bias the exchange rate upward or downward. “Adjustable Pegs” are situations where the government fixes the rate temporarily—for months at a time or daily, as in the case of China. It is only with a few major currencies, such as the dollar or euro, that the government allows a “Free Float” with minimal or no intervention.
Figure 1: Percentages of IMF Member Nations Intervening in Foreign Exchange Rates (Source: IMF)
What exactly is behind the accusation of “currency manipulation”?
Generally, the accusation alleges that the government is keeping its currency too weak, overly devalued, or undervalued in order to give an artificial boost to exports while keeping out imports. This has the effect of boosting jobs in that country.
Take China as an example. A Chinese exporter earning a dollar turns it into the bank and gets 6.4 RMB yuan. By comparing costs in China and elsewhere, IMF and other economists calculate a hypothetical purchasing power parity (PPP) rate of 5.7 RMB/$, which would supposedly prevail under market equilibrium and without government meddling. At 6.4, some economists argue the RMB is still undervalued. But if the theoretical rate of 5.7 RMB/$ were to happen, the Chinese exporter would get only 5.7 RMB per dollar at the bank counter. The 6.4 RMB/$ rate provides a 12 percent higher revenue to the Chinese exporter, compared with the hypothetical 5.7 RMB/$ rate that some economists say should prevail. The still-undervalued 6.4 RMB/$ rate, they allege, gives the Chinese exporter an advantage.
By the same token, imports into China cost 12 percent more at the allegedly undervalued 6.4 RMB/$ rate than at the PPP 5.7 RMB/$. This, they allege, makes imports into China 12 percent more expensive than they should be, thereby keeping some foreign products out of China and benefiting (or protecting) Chinese firms that produce substitute products that compete with imports. On both the import and export side, an undervalued exchange rate boosts or preserves jobs in China (at the expense of jobs in the rest of the world).
But the Chinese have already massively appreciated their currency since 2005…
It must be particularly galling to the Chinese to hear accusations of currency manipulation since, succumbing to pressure from Western countries, they have already massively appreciated their currency in the 10 years since 2005. In June 2005, following more than a decade of a fixed exchange rate at 8.27 RMB/$ (when it was indeed undervalued), the Chinese gradually appreciated their currency all the way to 6.2 RMB/$ by July 2015. In the minds of many Chinese economists, their currency is no longer undervalued at around 6.2 for three reasons:
1. Between June 2005 and July 2015, the RMB appreciated/strengthened by 36 percent (see Figure 2)
This means that Chinese exporters in 2015 earned as much as 33 percent less that they would have at the 2005 exchange rate. Several Chinese exporters found themselves uncompetitive with the stronger currency and had to shut down their operations in China and relocate production to Vietnam, Bangladesh, or Africa.
Figure 2: China’s RMB Exchange Rate History (Source: Oanda.com)
By the same token, imports into China costing 33 percent less in 2015 than in 2005 means that some Chinese domestic production was displaced by imports.
In both cases, the appreciation of the yuan (RMB) has meant reduction of jobs in China, although this is consistent with the peaking of the Chinese labor force (partially as a consequence of the one-child policy). Indeed, several areas in China have labor shortages.
2. The yuan (RMB) has appreciated even more against other currencies
The PBoC fixes the RMB only against the US dollar. But in the last two years, this has meant that as the dollar has risen against most other currencies (such as the euro or emerging-country currencies such as the Brazilian real), the RMB has appreciated or strengthened even more, piggybacking on the dollar (see Figure 3).
Figure 3: The Yuan (Reluctantly) Piggybacking on the US Dollar
(Source: The Economist, May 30, 2015)
If one combines the RMB appreciation in Figure 2 (36 percent) with the dollar’s appreciation against most other currencies since 2013 (15 percent), the local currency cost of importing Chinese products may have risen by more than 50 percent since 2005 for many prospective buyers in a large swathe of nations from Europe to Brazil.
3. Chinese wages and costs have risen
On the east coast of China, where most of its manufacturing and economic activity takes place, wages have recently been rising at least 15 percent each year. Some jobs go unfilled. The one-child policy (reversed in 2015) has led to a plateauing of the labor force. Other costs, such as real estate, have also risen sharply. Chinese exporters are beginning to feel a squeeze between (i) rising costs and (ii) the falling RMB conversion value for the dollars or foreign currencies they earn.
So, why pick on China?
By massively appreciating their currency, the Chinese have succumbed to Western government pressure. While most economists aver that the yuan (RMB) is still undervalued, they agree that in 2015 it is not undervalued by much.
Indeed, if one were to search for a more egregious recent example, it would be the Japanese yen, which has been consciously devalued by the Shinzo Abe government by around a third since November 2012.
Figure 4: Yen per Dollar Exchange Rate November 2012–November 2015 (Source: Oanda.com)
One of the Abe government’s top priorities on taking office was to drive the yen downward (devalue it) from a historically high overvaluation of 80 yen/$ (at which rate few Japanese exporters could make any money) to a more devalued rate of 124 yen/$ (by 2015 when Japanese exporters could make profits). The math is simple. At 124 yen/$, each dollar earned by the Japanese exporter converted into 55 percent more yen, compared with the 80 yen/$ rate. In retrospect, it seems astonishing that so many Japanese governments prior to Abe’s allowed the yen to remain at an overvalued rate of 80–100 per dollar, which not only grossly dampened Japanese exports, but also put the economy into the doldrums for so many years. Most economists would agree that at around 115 yen/$, the yen would be appropriately valued—that 80 was too high and that perhaps the 124 yen/$ at end 2015 is a tad too low. At any rate, the Abe government’s actions have jump-started the Japanese export engine and restored a plethora of Japanese exporters to profitability.
But is this not also a case of currency manipulation by the Japanese? And, as noted above, the IMF reports that more than half of the world’s governments have a hand in influencing or adjusting their exchange rates.
So why then pick on only the Chinese, especially if, at 6.2 RMB/$ and with rising costs inside China, they are not too far from a realistic PPP rate in 2015?
Donald Trump, please read this post.
Also see my May 8, 2014 post: Whither the Chinese yuan? Is the RMB still undervalued?
© 2015 Prof. Farok J. Contractor, Rutgers University
NOTE: This post was updated on the main site May 5, 2016:
A version of this article was also published in AIB Insights, Vol. 16, No. 2 (2016).
Contractor, Farok J. Tax avoidance by multinational companies: methods, policies, and ethics. Rutgers Business Review, Vol. 1, No. 1, pp. 27–43 (2016).
Also see other posts: The  G20 Summit in China: An Annual “Talking Shop”? Or a Potential Bedrock of Global Civilization? and Tax “Amnesty” for Multinationals—But Not for Illegal Immigrants.
The question of multinational companies avoiding taxes is inevitably going to become a hot issue for the US, Europe, and other major economies. Voices from both the political left and right have an ax to grind.
Moreover, three separate tax issues—(1) the average tax US-based multinationals actually pay, (2) accumulated, but not repatriated, profits of US-based multinationals’ foreign affiliates, and (3) inversions—are often conflated, creating muddled perspectives.
The observations below may help to separate and clarify the issues.
Three Related—But Separate—Tax Issues
1. The Average Tax US-based Multinationals Actually Pay
The marginal corporate tax rate in the US is indeed among the highest in the Organisation for Economic Co-operation and Development (OECD) group of rich nations. But few US-based multinationals come even close to paying the 35% marginal rate because
They know how to take advantage of “transfer-pricing” techniques, including
– Export shipment invoicing (for tax and tariff avoidance)
– Licensing (royalty payments) between affiliated entities
– Intracorporate loans
– Charging central fixed costs and overheads to various affiliates
They shift intellectual assets such as patents and brands to tax-haven subsidiaries, such as Bermuda or Luxembourg, and then make the tax-haven subsidiary a licensor, charging substantial royalties to the rest of the company’s network. This has the effect of sucking away taxable profits from affiliates in high-tax jurisdictions to Bermuda, Luxembourg, etc., where the effective corporate tax rate is closer to zero.
In general, multinationals have the discretion to locate value-added and profit-generating activities in lower-tax nations such as Ireland, where (so far) corporate tax rates are capped at 12.5%.
So multinational companies effectively pay a rather low average effective tax rate because they can shift and relocate tangible (e.g., factories) as well as intangible (e.g., patents) from one nation to another—thus lowering global total tax liability.
Many observers confuse the marginal 35% US tax rate with the often much lower effective average tax rate actually paid by multinational firms. Incidentally, domestic US companies, especially medium and small firms, do not have the luxury of taking advantage of the myriad available deductions and loopholes, and so end up paying a much higher average tax. (No wonder, then, that the Tea Party base consists of small- and medium-size company owners and employees.)
2. Accumulated, But Not Repatriated, Profits of US-based Multinationals’ Foreign Affiliates
The US is one of the few countries that taxes corporate profits, not only on US operations, but also on US multinational companies’ foreign affiliates. That means that the foreign affiliates of US firms not only first pay tax to the country in which they do business, but their profits are additionally taxable in the US. This sounds like double taxation and a huge disadvantage to American firms, compared with European or other multinationals whose governments tax only profits generated in the home country. Is the US policy of double (or additional US) taxation a big drawback?
But then, there is a huge loophole—big enough to drive a truck through—because US regulations allow indefinite deferral of the additional US tax on foreign income until the money is actually remitted back to the US. Effectively, this means that a US multinational’s foreign subsidiary profits are not taxed—even for decades—as long as those profits are not actually remitted back to the US parent company.
Unsurprisingly, US multinationals simply keep their foreign affiliate profits outside the US and do not bring those profits home. Why should they? Besides, there is no shortage of investment capital in the US for additional investment for the American market. Foreign affiliate profits either accumulate in tax havens abroad or are reinvested in faster-growing countries outside the US.
As a result, as of 2015 between $2 and $3 trillion in accumulated foreign affiliate profits (after paying foreign corporate income tax) have not been brought back to the US. After reading SEC filings, the Citizens for Tax Justice and the U.S. Public Interest Research Group (U.S. PIRG) Education Fund (organizations normally critical of multinational firms) concluded:
Apple alone held $181 billion in un-repatriated foreign profits.
GE’s foreign operations had accumulated, but not repatriated back to the US, $119 billion.
“At least 358 companies, nearly 72 percent of the Fortune 500, operate subsidiaries in tax haven jurisdictions as of the end of 2014,” and “all told these 358 companies maintain at least 7,622 tax haven subsidiaries.”
Other observers estimate the total accumulated amount is in excess of $3 trillion. (It is worth noting that voices from both the left and the right intentionally, or ignorantly, make the mistake of stating that the US corporate tax rate is 35%. On the right, this 35% figure is periodically trotted out to support the assertion that US taxes are too high. On the left, the 35% figure is used to miscalculate and overstate the dollar profits that US firms would pay if foreign affiliate profits were actually repatriated. Both groups ignore the fact that the maximum rate of 35% is reached only after several brackets of income, the lowest being 15%, and that several hundred pages of the tax code—deduction after deduction—allow firms, especially multinationals, to greatly reduce their tax liability.)
When an American company acquires or merges with a foreign firm, it can then declare that the US is no longer the headquarters of the firm. The American company then becomes non-American, and thereafter is not subject to US regulations except for its US operations. Specifically, the company’s subsidiaries outside the US are no longer subject to additional US taxes. After the shift of headquarters, future non-US affiliate earnings are completely removed from additional US tax liability. The company continues to pay tax in the US for US operations’ profits as well as on past accumulated, but not repatriated, profits of non-US affiliates.
Are US Corporate Taxes Onerously High?
US corporate taxes do seem, on superficial examination, to be onerous. With a high 35% marginal tax rate (to say nothing of additional state and local taxes, which can bring the marginal rate above 39%) and with regulations that also tax foreign operations (unlike most other countries), the US sounds like a high-tax country.
But marginal should not be confused with average, or effective actual tax paid, after accounting for the literally thousands of deductions and loopholes, ranging from R&D credits, to deductible healthcare costs, to indefinite deferral of additional tax on foreign income—as long as foreign profits are not repatriated back to the US.
A PwC (Price Waterhouse) study using International Finance Corporation data comparing 189 nations concluded that the actual tax paid by all US companies—which are mostly domestic—was 27%. This is somewhat or significantly above the OECD average.
By contrast, multinational companies based in the US pay far less. They can
Take advantage of the several international transfer pricing maneuvers;
Relocate tangible (physical) operations to low-tax nations or tax havens;
Transfer (intangible) assets such as patents and brands to holding companies in Bermuda or Luxembourg;
Defer additional US tax on foreign source income indefinitely; and
Ultimately even shift headquarters away from the US.
Data on multinational companies’ tax payments are difficult to come by. But a Citizens for Tax Justice study examining filings between 2008 and 2012 by 288 large US multinationals found that they paid an average effective tax of 19.4%, and that one-third of the studied companies paid less than 10% on average.
US marginal tax rates are high. But then, hundreds of pages of deductions and loopholes exist in the US tax code, so that the effective average tax paid by corporations is substantially lower than the highest marginal federal bracket of 35%. In particular, US-based multinationals have the acumen, motivation, and international flexibility of shifting operations, intangible assets, and proprietary invoicing (transfer pricing) so as to pay much lower taxes.
In a world of increasing global business and a greater willingness of multinational firms to maneuver operations, two competing obligations seem to collide. How do we reconcile a government’s need to collect reasonable revenues to pay for social services, defense, roads and bridges, and so forth versus a company’s duty to shareholders to maximize after-tax income by taking advantage of loopholes passed by the same governments?
Stay tuned for more on the techniques, maneuvers, and ethics of international taxation in a future post.
 See above Reuters article quoting Citizens for Tax Justice and the U.S. Public Interest Research Group Education Fund
 PwC–Price Waterhouse: Paying Taxes 2014: The global picture—A comparison of tax systems in 189 economies worldwide
 Citizens for Tax Justice: The Sorry State of Corporate Taxes
© 2015 Prof. Farok J. Contractor, Rutgers University
Chinese President Xi Jinping and US President Barack Obama. Joint news conference, Washington, DC, September 25, 2015.
PHOTO: PETE MAROVICH/BLOOMBERG NEWS (WALL STREET JOURNAL)
American companies state that their secrets are being stolen by Chinese hackers. US counter-intelligence says it has traced several of these attacks back to outfits sponsored by the People’s Liberation Army (PLA), and that designs stolen from American companies’ computers have shown up—sometimes barely disguised—in Chinese companies’ products and services. The Obama administration has threatened sanctions against hackers and Chinese firms that benefit from such intellectual property theft.
But wait a minute! Isn’t the “pot calling the kettle black”? The US has by far the best cyber-capability in the world and has used it to spy on millions of international communications, including Angela Merkel’s mobile phone—as well as to gather data from both European and Chinese companies’ computers. It can access any Internet-connected device, anywhere, to read its contents. So well-developed is the US government’s data-mining and cyber-capability that it has harvested detailed information, even family photos, on the very PLA hackers that penetrate American companies’ computers.
This is a “game” played by most major governments. So why single out China?
The “pot-and-kettle” analogy has a flaw: it is not symmetrical. The legal and political systems of the two nations tilt the game in China’s favor because:
The Chinese government can, and does, share its information with its companies—especially State Owned Enterprises (SOEs)—whereas the US government cannot, for a myriad of legal and ethical reasons.
SOEs, or government-controlled firms, still make up a major fraction of the Chinese economy, accounting for 34 percent of fixed total investment. Some observers indicate that state ownership in China has continued to grow, not shrink, especially in key sectors (although the growth rate of private enterprise is even higher). The government-owned sector in the US, by comparison, is minuscule.
As US firm CEOs made it clear to President Xi Jinping during his Seattle visit in September 2015, US companies in China are increasingly being squeezed and pressured to share technology and proprietary designs with Chinese partners as a precondition for doing business in China or getting access to markets. In brief, the Chinese government makes no bones about its drive to help its companies learn from US and European firms. Neither the US nor Europe makes any such demands on foreign investors.
The “pot calling the kettle black” notion does not, therefore, really hold up, even though the hacker abilities of US government or private experts are most likely superior to their counterparts in China. In the US, the role of government and its interests are separate from those of private business. The Chinese government sees its role as allied and interpenetrated with business, both SOEs and privately held companies. The Chinese have a very different notion of nationalism, and solidarity, that idealizes a utopian vision of all noses pointing in the same direction—one that promotes China. By contrast, the American War of Independence from Great Britain was fought largely on the very principle that government should keep its nose out of private business, and not tax or overly regulate commerce.
The farthest the US government goes in scrutinizing some incoming foreign direct investment (FDI) is through CFIUS (the Committee on Foreign Investment in the United States), chaired by the Treasury Secretary, that each year examines a handful of investment proposals that are sensitive in terms of defense or some vital strategic interest of the US. In 2010, Tangshan Caofedian of China wished to acquire Emcore, a US fiberoptics and solar panel producer, but scrapped the deal because of objections from CFIUS. In 2006, Dubai Ports World withdrew its agreement to take over the management of three US ports. Because of ideological embarrassment, the US government openly admits only to examining a handful of such sensitive cases each year, although CFIUS staffers, the Commerce Department, and the CIA probably cursorily and quietly screen thousands of FDI proposals behind the scenes. After all, the US is the world’s leading exponent of free markets and international business.
But the PLA-sponsored hacking poses a policy dilemma. What policy options does the US government have? Should the American government share commercial secrets it has gleaned from Chinese or European firms with US companies? Clearly, it cannot. Should the American government expand its scrutiny of incoming FDI, or even “encourage” foreign companies to share their technologies locally? That would be going against the principles and ideology of free markets, open entry, and separation between commerce and government. Should the American government sanction Chinese firms that have clandestinely appropriated American designs? That, too, is highly problematic since—in an interdependent world where US-China trade alone is worth half a trillion $US each year—sanctions would invite retaliation and a further squeeze on US companies invested in China. Retaliatory sanctions would further undermine the already fragile state of international business.
With the US and China alone making up approximately one-third of world’s gross domestic product (GDP), a commercial war between the two could be ruinous to the entire planet—leaving no more pots and no more kettles to judge each other.