China's Currency Conundrum

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ShanghaiUnderground
StreetBeater

Joined: July 15, 2004
Posts: 2413
Location: Shanghai

Posted: May 20, 2005 - 04:30 AM
Post subject: China's Currency Conundrum

It would surprise me if China revalued (or up-valued) its currency sooner rather than later, if at all. But I wouldn't mind being proved wrong.

Further below, an article on the subject from The Economist.

And here, a quote from Larry Kudlow, a respected (at least in my eyes) economics/financial analyst from the US:

Quote:

"Have the U.S. Treasury, the G-7, and the IMF forgotten the recent history of misbegotten currency manipulation? When several Asian currencies were forced to de-link from the U.S. dollar in the 1990s, world deflation followed. Floating exchange rates were a big mistake then, and could be a big mistake now."

If I remember correctly, George Soros, one of the major contributors to the political left of the US, had a major play in bringing about Thailand's and Malaysia's economic fall in 1997. I suspect that this alchemist of finance plays all sides of the political spectrum, as any cutthroat businessman should, I suppose.

Quote:

China's currency conundrum
May 18th 2005

http://www.economist.com/agenda/displayStory.cfm?story_id=3982328

As protectionist sentiment grows in Europe and America, China faces increasing pressure to revalue its currency. Domestic financial considerations are also making a revaluation look more attractive. But the road to a freer regime for the yuan is full of potential pitfalls, and Beijing is reluctant to be seen caving in to foreign pressure.

TO HEAR American and European officials talk, you might think China was flooding their countries with toxic waste, instead of affordable consumer goods. Both the European Commission and the American Congress have begun proceedings to protect their citizens from the threat of cheap Chinese textiles. Both are unhappy with the effect of China’s currency peg to the dollar—America because it makes inexpensive Chinese goods even cheaper, and Europe because the euro is having to bear the brunt of the dollar’s depreciation. On Tuesday May 17th, America’s Treasury gave warning that unless China relaxes its peg, it is likely to be classified as a currency manipulator. In Congress, a proposal is afoot to slap punitive tariffs on Chinese goods unless the yuan is revalued within six months.

The political logic of tariffs is clear; the reasons for pressuring China to revalue, less so. China’s currency peg, at around 8.28 to the dollar, is widely believed to be keeping the yuan undervalued by 15-40%, making Chinese exports artificially cheap. But it also subsidises a great deal of America’s profligate spending. In order to maintain the peg, China is forced to buy loads of dollars, which are then dumped into US Treasury bonds, financing America’s hefty deficits. A sudden decline in Chinese demand for Treasuries would raise America’s borrowing costs, curbing Congress’s ability to dole out pork to constituents. Some economists fear that this would push interest rates up sharply enough to cause a sharp contraction in the debt markets (including the mortgages that are fuelling America’s housing boom) and the economy.

If it is hard to tell whether American politicians are just blustering to impress their constituents or really mean it, it is even harder to tell what effect their remarks are having. The markets are abuzz with talk of imminent yuan revaluation, but such hopes have surfaced many times before, and the Chinese government has so far disappointed. Last week the People’s Daily, an English-language Chinese paper, reported surprisingly specific plans to revalue the currency, only to quickly retract its story, claiming a translation error. However, some observers wondered if the publication had in fact been used by the Chinese government to test the waters.

Certainly, the head of China’s central bank has recently been making noises that sound an awful lot like “revaluation”. But other officials are reluctant to tamper with a peg that they perceive to be working well. This week Wen Jiabao, China’s prime minister, thundered that his country would not bow to outside pressure on the yuan. Indeed, many economists think that hotter rhetoric from American politicians will only make China delay any revaluation plans it is working on. Perhaps the best way to speed things up is to keep quiet.

Either way, revaluation looks tricky for the Chinese government. It believes that for the sake of political and social stability, it needs 15m-20m new jobs a year. Increases at that level will be enough to absorb population growth, plus displaced workers from the agricultural sector and China’s ailing state-owned firms. And the export sector is seen as a crucial vehicle of job creation.

But this is not the only reason that Chinese politicians are reluctant to revalue. By some estimates, as much as three-quarters of China’s foreign-currency reserves are held in dollars; if the central bank allows the yuan to rise against the dollar, it will also in effect be allowing the value of its reserves to depreciate. Moreover, if slowing the flood of dollars that China’s central bank is pouring into American debt markets causes those markets—and the American economy—to contract, China’s exporting firms will have worse problems than a more expensive yuan. And problems for those firms could translate into big trouble for China’s frail banking system.

On the other hand, revaluation has its advantages. In order to “sterilise” its foreign-currency operations, preventing them from causing domestic inflation, China’s central bank has been issuing domestic securities. These have been stuffed into the banking system, which may be reaching the limits of its ability to absorb such infusions. Revaluation would ease this problem.

It would also mean that monetary policy could focus more on controlling the money supply, less on maintaining the currency peg. With economic growth hovering close to double-digit levels, fears of an overheating economy, and the attending inflation, are coming to the fore. And because per-capita GDP is so low—only $1,226 in 2004—large swathes of the population are vulnerable to even small increases in inflation; price instability could quickly become political instability. But China’s capital controls and currency peg make monetary policy much harder to execute.

As pressures are growing at home, so they are mounting in America, where all those cheap goods, and cheap loans, are fuelling a buying binge that cannot last. America’s national savings rate has already plunged to razor-thin levels, and each passing month of spending more than they earn leaves households more vulnerable to a sharp rise in interest rates when the Chinese stop lending. Despite the immediate political fallout, it looks like both America and China would be better off taking their medicine now, rather than dragging things out in the hope that a miracle will intervene.

Don't expect too much

But even if China does revalue, it will not be the salvation that American politicians are praying for. First, it is highly unlikely that the yuan will be allowed to rise very far; even optimists expect a revaluation only in the range of 3-10%, which will still leave the currency seriously undervalued.

Moreover, the effects of a relaxed peg on America’s current-account deficit will be extremely modest. China accounts for less than one-tenth of America’s trade, so even a 10% revaluation would only reduce the trade-weighted value of the dollar by 1%—not enough to produce any noticeable change in America’s current account. Nor is it clear that even a big revaluation would help much. Morris Goldstein of the Institute for International Economics estimates that even a 25% revaluation would reduce the current-account deficit by less than 5%.

Nonetheless, China seems to be preparing the way for a slightly freer currency. This week it allowed some foreign currencies to be traded against each other for the first time in China. This is widely seen as a preparation for reform of the tightly controlled currency regime. And if a revaluation seems unlikely to please America’s protectionist politicians, it should nonetheless help to correct the imbalances caused by the gaping American current-account deficit, if only by weaning America’s spendthrift consumers—and government—off cheap Chinese credit. If the hour of reckoning is not quite at hand, it seems only a matter of time before China’s financial system, and America’s borrowers, begin to grow up.

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busyexpat

Talker

Joined: May 20, 2005
Posts: 101
Location: Hong Kong
Status: Offline

Posted: May 21, 2005 - 12:29 AM

It is my understanding from a very great deal of research and news following, that China is going to revalue the RMB in the second half of this year. But, as the Economist article points out, the revaluation won't be huge.

Therefore look out for future comments in the news such as "China moves on currency, but politicians say not enough".

One very respected economist I have talked to in Shanghai told me that if the USD falls another 10%, China will be FORCED to revalue for economic reasons. Now, seeing that the USD is currently rallying (to six month highs against the Thai Baht, for instance), pressure is being relieved on this force option. Another point, is that there is too much ego involved. China just won't bow to demands from countries such as the US, and if the US keeps bullying China, then there will be delays...simply, really, to save face.

It should be remembered too, that China still has a communist government and still employs many aspects of a planned economy...therefore, there is not going to be any rapid increase in the RMB conversion rate that might threaten to plunge China into economic chaos.

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