“Save money. Live better.”
This is the promise that the world biggest retailer “Walmart gives to customers since they started business back in early 1940. Low price has always been Walmart strategy. Since their early days, they claimed “We Sell for Less” as their tagline. Later on, “Always Low Prices. Always” displayed alongside with Walmart logo. The biggest challenge for them is to keep the price down with good product quality. Why does Walmart important for American economy and beyond? According to the figures from Charles Fishman’s book The Walmart Effect, more than half of all Americans live within 5 miles of a Walmart. Every week, more than 100 million Americans shop at Walmart (1).
In comparison to the similar scale of American companies like ExxonMobil, Walmart employs 1.6 million workers worldwide while ExxonMobil employed about 90,000 people. Interesting to know that ExxonMobil is growing by raising prices, but Walmart is growing despite lowering prices (1). Walmart net sales in 2012 hit $443,854millions (increase by 5.9%) with the gross profit margin of 24.5% (2).
How does Walmart sell low price products and remain high margin of profit? PBS Frontline, a well-known TV program in the US pointed out on 2 aspects. First, Walmart managed to be the lead in technology and able them to track consumer behaviors. Knowing what consumers want and when they need it are not enough, they have to control the price of goods in order to complete with competitors (3).
Walmart found the same heaven as well as other American companies in China. In China, Walmart can offer low price products and still enjoy the widen profit margins. In fact, Walmart is distinctively different from other companies because if they were a country, they would be China’s sixth or seventh largest trading partner. In 2002, $12 billion of merchandises were import from China to Walmart. This was nearly 10% of all Chinese export to the US (4). The value of yuan has played an important role to make export goods from China very competitive in price. Unlike other currencies, the yuan has pegged to the US dollar instead of fluctuate freely.
Currency intervention in China makes the US goods less competitive against Chinese goods (5). US trade deficit with China has estimated reaching a record of $295.5 billion in 2011 (6). The US is concerned about China’s currency manipulation. Critics say that Chinese government has artificially undervalued yuan. American exporters are believed that they are facing unfair competition from the Chinese goods. The debate is on for good and bad side of the story.
Question 1: Why is value of Yuan is important?
The official currency that forms the spine of the monetary system in People’s Republic of China is Renminbi (RMB) or with its base unit Yuan (CHY). It is considered to be among the most important currencies being the national currency of one of the most rapidly developing nations of the world. China is taking an important step towards achieving one of its major goals for elevating itself into a global manufacturing and financial power as well.
Chinese economy is emerging out as a new powerful nation of the world supported by its economic growth and advancement. The nation’s prosperity and the currency has stood strong increasingly since its inception as the official one. Also thanks to the growing importance of China in global trade, the Yuan has been gaining value of a worldwide profile. The Yuan is being used more frequently in trade conducted between China and its trading partners.
Earlier, the Chinese Renminbi was unofficially pegged to the United States dollar under a fixed rate regime. This move proved fruitful in the context of currency’s strength but recently it had changed its basis to floating rate regime with some resistance under the pressure of the USA and other European and G7 countries.
Renminbi was pegged informally to United States dollar at a fixed rate that prevented the Chinese currency from the competitive devaluations of the Asian currencies. This policy was also taken off from execution under the pressure of United States and other countries. Now the currency is pegged to a basket of foreign currencies (including the United States, Japan, Hong Kong, the European Union, Indonesia, Malaysia, Singapore, Thailand, South Korea, Taiwan, Australia, Canada and 12 countries and regions in the currency) and not strictly the dollar.
Once we generally take a look at the exchange rate, there are factors affecting the exchange rates between two countries. The volatility in the foreign exchange rates depends upon a numerous macro economic factors that have different degrees of importance to different economies of the world. Some special and outstanding factors affecting the rates may also exist in the case of different countries. Thus, there are some factors of each currency, i.e. Yuan and US dollar in this case, and foreign exchange rates will be relevant and depend on, as follows:
- Flow of imports and exports between the countries
- Merchandise trade balance
- Flow of capital and funds for the payment between the countries
- Relative inflation rates
- Short term and long term interest rate
- Fluctuation limits on exchange rate imposed by the governments of the countries
- Relative growth
There are many factors affecting the conduct of foreign trade, such as commodity prices, exchange rate policy and other national policy. In the case between China and US, Yuan is more important to USD and US itself seeing that China is the US’s significant trade partner. According to the national beneficial advantage supports China to be one of the largest international exporters, the price of US’s imported goods must be related to Yuan. Therefore, the exchange rate will definitely affect US’s terms of trade (TOT) which will be related to the trade balance or its trade deficit or trade surplus.
Terms of trade or TOT is (Price of exportable goods) / (Price of importable goods).
It means what quantity of imports can be purchased through the sale of a fixed quantity of exports. “Terms of trade” are sometimes used as a proxy for the relative social welfare of a country. An improvement in a nation’s terms of trade (the increase of the ratio) is good for that country in the sense that it can buy more imports for any given level of exports. The terms of trade is influenced by the exchange rate because a rise in the value of a country’s currency lowers the domestic prices for its imports but does not directly affect the commodities it produces (i.e. its exports) (7).
The value of a country’s exports relative to that of its imports. If a country’s terms of trade (TOT) is less than 100%, there is more capital going out (to buy imports) than there is coming in. A result greater than 100% means the country is accumulating capital (more money is coming in from exports) (8).
Once the Chinese’s government is controlling and keeping their currency relatively low to get more economic advantages. This is one of the reasons of why Chinese products are cheaper than the American products. Thus, there is the impact of exchange rate on import and export trade which should be as a main factor. Economics, common sense tells us that the currency appreciation, means that other country’s currency devaluation and vice versa. So the importing country may turn to seek other countries of goods which is not conducive to their export markets. The change in exchange rates is the most direct expression of appreciation or depreciation of the currency.
Currency appreciation would result in lower prices of imported goods and sometimes can help improving the international balance of payments. On the other hand, the devaluation of the currency impact on revenue mainly from two aspects: the devaluation will cause the higher prices of imported goods, the export prices fell and could make the deteriorating terms of trade. This will cause the domestic general price level increase.
Consumers can only buy fewer goods, which is leading to a decline in real incomes, which will inevitably lead to a decline in spending in the country. However, currency depreciation makes the foreign exchange reserves increased, but also more of the base currency will be inflationary. When inflation occurs, in fact, is to encourage people to spend money. But countries may also suffer from extremely high inflation as well. The revaluation of the Yuan would make imported goods at Walmart in this case become more expensive.
Revaluation means a rise of a price of products. Revaluation of a currency means a rise of currency to the relation with a foreign currency in a fixed exchange rate. In floating exchange rate, the correct term would be appreciation. The antonym of revaluation is devaluation (9).
In the case of RMB appreciation, it has an impact on import and export trade. The exchange rate issue and the national economy is closely related to an important international financial issues, exchange rate appreciation or depreciation of a country’s foreign trade will have a significant impact. The rapid development of China’s foreign trade has accumulated a large trade surplus and foreign exchange reserves, so other countries including US are facing pressure of RMB appreciation. The RMB exchange rate pegged to a single U.S. dollar will no longer form a more flexible RMB exchange rate mechanism.
China used to announce revaluation of the Yuan against the U.S. dollar to achieve exchange rate reform only for a short while. This new change of financial market of China, the world will undoubtedly have a profound impact on the economy. China’s economy expands domestic demand, driven by growth in investment and foreign trade. If a country can maintain stable economic growth, it will support the appreciation of its currency stability. China’s trade surplus continues to expand, particularly from the United States.
China’s huge foreign exchange reserves, the public state needs to maintain a certain amount of foreign exchange reserves to support the national currency exchange rate stability, enhance the macro-control ability, and also corporate reputation in the international arena. Thus, the RMB appreciation can improve terms of trade and increase in trade surplus because will reduce the prices of imported products. Companies will accelerate the technology, improve production efficiency, product upgrading and achieve comparative product upgrades. This will help in better use of the world’s resources, increasing people’s welfare (as most enterprises are in the labor-intensive), and enhance the international competitiveness of Chinese products.
Nevertheless, because China’s the processing trade are also imported raw material, parts or high tech equipment, semi-finished products, and production in China and then later re-export. With the upgrading of China’s industrial structure, the rapid development of industries and export products needed for the production of raw materials, it will be more by domestic manufacturers, the exchange rate adjustment will also have effect on its export trade expansion. The impact of currency appreciation on exports is when the use of national raw materials, production for export, would significantly increase the price of export commodities and resulting in reduced exports.
Thus, RMB Depreciation against U.S. Dollar is accepted and brought in the policy as well. Once China’s Renminbi is dropped against the U.S. dollar, the weaker RMB makes Chinese exports more attractive to those importing Chinese goods, but raises the price of foreign products imported by China. This means signifying slower the growth within China’s domestic economy and continuing the need to support a strong export focus.
So the U.S. trade deficit with China will be occurred. However, it is possible that foreign investors and Chinese citizens have been taking their money out of China, thereby contributing to the fall of the RMB. Strengthening the export, the economy would need plenty of jobs in China, but would also hurt the economies of the other emerging markets supplying the same products as well. China is beginning to export more high-technology products, such as telecommunications equipment which are usually made in the United States, Europe, and Japan.
Thus, China’s low costs are also hurting the manufacturing businesses in these countries. Furthermore, if we focus on Walmart’s trade deficit with China, it has also eliminated a large number of U.S. jobs. The manufacturing sector and its workers were hardest hit by the growth of Walmart’s imports as well. The growth in trade deficits with China has reduced demand for goods produced in every region of the United States and has led to job displacement in many states.
In order to respond to changes in exchange rates from the import and export trade diversification, there is the use of various financial instruments. Firstly, select diversified sources of imports. It must be a proper expansion in the geographical distribution of import and export business in the international circumstance of dispersed sources of raw materials and sales outlets. Some resources are too much dependent on a single country or region which China occupies this advantage. The country’s exchange rate risk will be passed on to importers.
In addition, the selection of a reasonable settlement and payment of money with the currency is concerned. The export trade denominates in case the exchange rate depreciation. Importers will choose soft currency, in order to avoid exchange losses resulting from appreciation. Once the RMB revaluation pressure, while the depreciation of the dollar comes, exporters wish for more of the Yuan currency for billing and payment, while importers are more willing to choose U.S. dollars settlement.
Question 2: If you were the CEO of Walmart and were preparing for a meeting with the most vocal members of the US Congress on China´s currency “manipulation”, what would you say to them?
Some argue that the Yuan has to appreciate and the Dollar to depreciate to enhance the US-firms competitive advantage compared to Chinese companies. But this kind of strategy might not be pleased by every company. Especially, those companies which benefit by importing goods from China are in favor of a cheap Yuan. Such a company is Walmart which operates globally and obtains a big amount of products out of China. Assuming Walmart would be a country, the company is the eight largest trading partner of China.
This symbolizes the scope of an undervalued Yuan for the company. If the currency will become appreciated most of Walmart´s suppliers (almost 80 %) will get into trouble and Walmart will no longer be able to offer its products at “Walmart” prices. As a result, Walmart´s success strongly depends on China´s currency. Therefore, Walmart´s CEO should try to defend China´s currency “manipulation” in front of US Congress to protect its own business. Out of his view, the preparing CEO should point out the advantages of a low Yuan for American economy and try to weaken the arguments against an undervalued Yuan. Therefore we will in the following text focus more on the advantages of an undervalued Yuan for US economy than on its disadvantages.
Many analysts claim that the undervalued Yuan is one reason for the US trade deficit and moreover for hindering economic growth. Due to cheap prices of in China produced goods, the American industry gets into trouble because they are not able to compete into global price competition. As a result of this, the US job market is jeopardized and the trade balance especially referring to China is negative (10). By analyzing the US trade deficit it becomes obviously that 40 % of all American imports are made in China.
This reflects two facts. First, that it exists a high demand for Chinese goods in America and secondly that both consumer and the industry depends on that cheap products. Although these high demand is probably just founded in the Chinese price structure and China´s currency manipulation instead of the product quality, one has to ask, what might happen if the currency appreciate to its real value. Assuming Chinas currency might get appreciated a lot of companies and business models run into danger because the procurement of raw materials and consumer goods definitively will become much more expensive.
Referring to the American industry one has to mention that a lot of companies run subsidiaries and Foreign Direct Investments in China which are also directly affected by that currency structure (11). Following table points out the Net Foreign Direct Investments in China. In total one can say that 60% of in China produced goods are fabricated by foreign companies which profit by China´s current currency policy.
Moreover, with the view on the consumer side, the undervalued Yuan allows American consumers to profit by cheap prices of many consumer goods. Regarding to the “Closing Case” about 70 % of consumer goods are made in China. Regarding to Walmart, a big amount of suppliers with subsidiaries in China allows the company to set incomparable low prices comparing with its competitors. As Walmart claims, its way of setting prices saves the average American household more than 2,500 US $ each year.
This implies that each American inhabitant should be able to spend 2,500 US $ each year for further consume which vice versa stimulates the economy and enhances the life quality. Assuming that prices for consumer and industrial goods increase, the general demand for Chinese as well as American goods will decrease because of higher prices. This in turn results in negative effects for a country´s economy.
Next to the higher prices for procurement of raw material, industrial goods as well as consumer goods which directly affects American economy, Walmart´s CEO should point out that USA are not able to reach economies of scales in that extend in which China is able to generate them at the moment. One reason for that is based in Chinese salary structure.
By comparing the average wage of Chinese and American factory workers one can highlight that the average hourly wage for Chinese manufacturing workers is less than a tenth that of their average US counterparts (13). Due to that salary structure it seems obvious as well as efficient, in context of earning competitive advantages, to procure simple goods from China and relocate challenging activities to USA where the work productivity and the labor skills are much higher.
Next to that main aspects, another positive side effect is that American tourists who are traveling to China profit by the undervalued Yuan. All in all, there are various reasons which suggest that China´s currency manipulation has also positive effects on American economy and that trading with China has not just adverse impacts. This positive impacts should Walmart´s CEO highlight and explain to the US Congress.
Question 3: Should Walmart do something about the US trade deficit with China?
In order to analyze whether Walmart should put some action on the US trade deficit, we need to know what the trade deficit is and what the trade deficit’s effects are. Trade deficit is an economic measure of a negative balance of trade in which a country’s import exceeds its export. A trade deficit represents an outflow of domestic currency to foreign market, so when the domestic company ships the raw material to its plant aboard, that is counted as an export. When the finish good is shipped back home, that’s counted as an import.
Most people consider trade deficit as a bad thing but it actually causes both good and bad effects. Concerning to the good effect, the trade deficit can raise the standard of living because consumer can access to the wider variety if goods and services with more competitive price. It can also prevent the inflation because the goods is priced lower. On the other hand, the trade deficit can cause the job outsourcing because the domestic company has less consumer’s demand so the in house production also decreases. As the result, fewer jobs are available in country, more worker are required in the foreign country.
As China is a main production base of Walmart goods, Walmart will definitely earn profit from import from China. The more Yuan depreciates against Dollar, The more margins Walmart can gain. As the result, Walmart will do nothing about the trade deficit with China in the short run.
In the contrast, the situation will be changed depend on the Chinese currency value. When China exports more than imports, it causes the overheating of an economy. The overheating is economic situation in which growth is occurring so quickly that economists fear a rise in inflation. This happens when producers are not able to make enough goods and services to meet rising demand, and raise prices instead (14).
So in order to solve the problem, Chinese government has to make the Yuan more appreciate, which would affect Walmart in the long run. When the Yuan value is appreciate against Dollar, the cost of Walmart’s goods would be higher and the margin gain will be lower. This is the time Walmart need to put some action in order to retain its profit. For Example, Walmart might consider moving the production base to other countries such as India or Vietnam. Refer to Chris Devonshire-Ellis, principal of Dezan Shira & Associates, recently calculated and compared the manufacturing costs in the three countries during an interview with South Africa’s largest weekly newspaper The Sunday Times.
According to Devonshire-Ellis, if an employer based in China’s Dongguan hires about 300 workers, and pays off various monthly overheads such as welfare costs and rental, his/her annual expenditure will stand at around US$2.28 million. In contrast, a similar type of factory in Vietnam’s Ho Chi Minh City will only cost an employer about US$650,400 annually, and the annual operation costs of the same factory in India’s Chennai will even be lower at US$345,782.
“It’s a big enough gap to consider. It is financially more attractive to manufacture in India than in China,” Devonshire-Ellis says (15). In the conclusion, Walmart can enjoy the high profit margin and do nothing about the US trade deficit with China only in the short run but in the long run, they need to put some action in order to retain its Walmart price, which causes from the Yuan appreciation against Dollar.
Question 4: Assuming that the Yuan will appreciate further against the dollar, what should Walmart do?
The meaning of Yuan’s appreciate is Yuan’s monetary authorities intervene to maintain their currency undervalued against the dollar. More than 70% of the commodities sold in Walmart are made in China. Walmart replies significantly on Chinese made are imported, with the low cost of manufactures and low cost of labor. Walmart makes billions by bringing most of their products from China to America.
Assuming that Walmart continues to import about 7% of its sold inventory from China, a 3% rise in the Yuan could increase Walmart’s cost of goods sold by $900 million. All things equal, this would reduce gross margins by approximately 20-25 basis points. And if Chinese producers pass on their increased manufacturing costs to Walmart as we expect, the company’s gross margins would be reduced by an equivalent or greater amount (16).
There are a number of strategies that Walmart could do to improve the disadvantages from Yuan’s appreciation.
First strategy is that in the case Yuan appreciates, Walmart needs to intelligently strategize its source of products elsewhere other than China. There are more developing countries that have the needs to expand their products to American consumers. Countries like India, India has even made to world’s top 10 manufacturing countries. . India is also second largest population in the world. With promising potential that India can provider for American consumers, great natural resources. Another country that cannot be overlooked is South Korea, such a small country but with hi-tech technology.
South Korea could also become one great source for manufacturing and could offer low cost price with high quality which Walmart can use this advantage to gain more customers.
Based on UN information. Second strategy for Walmart to consider is that Forward contracts. The basic principle behind currency hedging is to exchange the currency while the rate of exchange is favorable, and then make the investment with currency that is native to the country of origin. This approach is adopted to safeguard the investor against fluctuation in currency exchange rate, and thereby preventing a monetary loss. Forward contracts are contracts that lock in a fixed exchange rate, for the receipts and payments.
This rate is usually the market determined forward exchange rate. What forward contracts do is offer stability to the receipts and payments. Both parties (the receiver and the payer) know exactly how much needs to be paid or received and the ongoing exchange rate on the date of the transaction hardly matters. This limits the losses but also limits the extra profits that could have been made, had the rate on the transaction settlement date been more favorable than the predetermined forward rate. An equivalent hedging strategy for foreign currency risks in the commodity markets, can be achieved through futures trading (17).
This may help Walmart in a short run in insuring the favorable rate with the manufacturers in China. This also offers stability for both Walmart and manufacturers in China. It is the exchange where both parties are satisfied with. Moreover, in the case that exchange rate in the market has not been as forecasted, Walmart can easily cancel this type of contract and use the present favorably rate. In short run Walmart should use this currency strategy to exploit Chinese market as long as possible to have enough time until to change its procurement strategy.
Walmart, by virtue of its sheer economic power and its business strategies, threatens to upset this balance, both in government and the marketplace. It produced $258.7 billion in revenues in 2003. It operated 3,400 stores in the U.S.; it intends to add, relocate, or expand more than 300 this year3 and 1000 in the next five years (18). Third strategy is that Walmart and others with small margins will be forced to increase their prices to cover the higher cost of buying things in China to resell in the United States. So the average price of all the things being sold in the U.S. will rise (inflation). Since Walmart is such important source of goods for Americans, if prices of initial products were to increase as to the effect of Yuan’s appreciation.
Walmart would require to join other related businesses to pressure US government to come up with policy to protect American consumers. Being the biggest contributor to federal parties and candidates, Walmart will definitely have the advantages in pressuring federal parties and candidates As mentioned in the research “Walmart: The Ultimate Lever for Major Corporate Change “ by Michael J. Marx, Ph.D. In the U.S., with contributions totaling $1.26 million in the 2003-2004 election cycle, Walmart became the largest contributor to federal parties and candidates. According to the Center for Responsive Politics, Walmart’s Political Action Committee operates as the second largest in Washington D.C., with 85% of its contributions going to Republicans.
Walmart is building its lobbying presence in our nation’s capital. It poured millions of dollars into the U.S. Chamber of Commerce’s Institute for Legal Reform in an effort to limit class action suits which had become a major strategic tool of its union opposition.
Walmart hired several attorneys with federal connections and expanded its Washington D.C. lobbying presence.53 The legislative targets on Walmart’s radar include: changing the banking laws to allow Walmart to offer its own banking services to customers, removing all tariffs on manufactured goods brought into the U.S., banning labor organizing activities outside retail stores, setting limits on class-action suits, protecting the company against immigration enforcement inspections which have found undocumented workers, reducing overtime pay, getting a seat on Commerce Department Advisory Committee on World Trade and allowing them to take part in the Cancun talks on the Central American Free Trade Agreement. Walmart proposed to the U.S.
Trade Representative’s (USTR) office several initiatives to advance in the 2002 General Agreement on Trade and Services (GATS) negotiations. Walmart requested that USTR push for no limits on store size, concentration, overall number of stores or anything else that affects their usual game plan. It requested trade liberalization of sectors for products they sell and greater “movement of natural persons,” the international analogue of “labor flexibility,” a tool for providing companies a large pool of cheap labor. Next strategy to help is that Walmart could do is import less products from China and have more production in America. Walmart could start to buy products in USA and other more developed countries. Even if the prices definitely will increase, the company can argue with a raise in quality.
Moreover company can spend a specific amount of money in new production techniques or new machineries which allows the company to procure products at lower costs and less labor. Last but not least, when the price of procurement increase and Walmart is forced to import less, the company has to save money in other areas to maintain its low prices. This could be done by outsourc