US to China: Revalue or... - or what?

Tuesday, May 10, 2005

After two years of futile debates American officials turn up the verbal heat on China with ever more heads popping out in ever more media, saying China has to revaluate the Yuan or otherwise...
Or otherwise what?
Any sanctions would backlash to the American homeyard and will therefore not materialize as it is China who has has the money and the goods and not the other way.
I wonder when China will silence the unilateral war of words by indicating it might reduce its build-up of dollar debt by reducing the bids in future treasury debt auctions. The current rate of federal US spending depends entirely on the Chinese will to accept more debt papers for the goods the American consumer is so willing to buy. Look into Wal-Mart's shelves!
The Yuan has been pegged against the dollar at a rate of 8.28 since 10 years. At the beginning of 2004, China held foreign exchange reserves of 415 billion dollars that grew to 600 billion dollars by the end of last year making it the second biggest creditor behind Japan which holds about 800 billion, according to the website of the People's Bank of China. This build-up corresponds roughly with last year's trade surplus with the US that amounted to 161 billion dollars. A revaluation of 5 percent only would result in a foreign exchange loss of 30 billion dollars to China. And once the Yuan would be floated, further attacks could be mounted against it, which could result in a hard landing for the Chinese economy. I am sure the People's Bank of China will not want its country to experience the same fate as the Asian tigers in the 1990's, when currency attacks transformed them into kittens in a matter of days. These economies have not yet fully recovered.
Stanford university professor McKinnon wrote already two years ago in the Asia Wall Street Journal:
China has become an important international creditor, with an ongoing balance of payments surplus from large inflows of foreign direct investment coupled with a small multilateral trade surplus. Because the dollar is the dominant international currency for borrowing and lending, that results in a continual buildup of liquid dollar claims on foreigners - a surprisingly high proportion of which are privately held, outside the direct control of the central government.
Chinese would dump dollars in event of revaluation
These ever-accumulating dollar balances need not disequilibriate the portfolios of Chinese savers holding both dollar and yuan assets as long as the yuan/dollar rate remains fixed within a narrow band. That's because a stable exchange rate means Chinese savers will see dollar assets as just as safe as those in yuan.
But once the exchange rate begins to fluctuate (even if the yuan does not immediately appreciate), the dollar assets will look riskier and private holders will begin to dishoard them, forcing an appreciation in the value of the yuan. And this appreciation will repeat itself as China's balance of payments surplus - large inflows of foreign direct investments plus small current-account surpluses - continues to produce liquid dollar assets that China's private sector will be less and less willing to hold.
China enjoys minimal stable inflation rates
As the appreciation continues, domestic price levels in China - which are now finely balanced between inflation and deflation - will begin to fall. And as China's financial markets begin to anticipate an ever appreciating yuan and falling prices, interest rates will be pushed down to zero, making it impossible for the People's Bank of China to stop the deflation - very much like the trap in which Japan now finds itself.
But this conventional wisdom is misplaced. China's trade surpluses reflect its surplus savings, just as America's huge ongoing trade deficit reflects the extraordinarily low net savings within the American economy - zero net personal savings and now large government dissaving from extraordinary fiscal deficits. Changing an exchange rate does not change these net savings propensities in any obvious way. However, in a deflationary world, if one country is forced to appreciate its currency against all its neighbors, the fall in its domestic-currency prices of tradable goods and services will create a downward deflationary spiral in prices and output with a consequent fall in imports. Thus, there is no predictable effect on China's net trade surplus from appreciating the yuan.
But just as diamonds are forever, so too should be the central rate of 8.28 yuan to the dollar.
Nothing of substance has changed since, except the mounting figures in favor of China. The Yuan is China's currency, but America's problem, to reverse a quote from former US president Richard Nixon, who once said, "the dollar is our currency, but your problem."
The political war-mongering against the Yuan-peg is not appreciated on the website of the conservative National Review either William P. Kucewicz warns, "The revaluationists better be careful what they wish for." He backs his warning with the following facts:
The yuan-dollar peg has produced numerous benefits for China, but senior among them has been pro-growth monetary stability. Chinese consumer price inflation has been docile, averaging just 1 percent year-on-year from January 2000 through March 2005 (versus a 2.6 percent U.S. average over the same period). Consequently, Chinese interest rate - both real and nominal - are also low. It's small wonder then that officials in Beijing have said the pressure to revalue the yuan is unfair and that the U.S., as well as other foreign governments, should "look into itself" for the source of any problems.
The true aim of the revaluationists is a change in the terms of trade with China. Their hope is to discourage imports from China by making them more expensive, not through protectionist tariffs or outright trade barriers but rather via an obliteration of China’s longstanding dollar peg and a substantial appreciation of the yuan.
The revaluationists better be careful what they wish for. While a stronger yuan would make China's exports dearer (at least temporarily), it also would make its imports cheaper. And there's the rub. Less expensive imports of raw materials, industrial equipment, manufacturing technology and the like would eventually translate into lower export prices (and higher quality goods) as input costs declined and labor productivity rose. Thus, any gain from a shift in the terms of trade would be transitory.
Dollar pegs should be encouraged
Finally, any disruption of Chinese monetary stability would have adverse repercussions for the growing global trend toward dollarization. Indeed, dollar pegs like China's shouldn’t be discouraged but rather encouraged. If a viable international monetary order were someday to be restored, replacing the current floating-exchange-rate system, the U.S. would likely employ a gold- or commodity-based price rule, with enough flexibility to avoid the rigidities that doomed Bretton Woods, and other countries would either follow the same rule or peg to the dollar - or even dollarize.
A severing of the yuan-dollar peg via a revaluation of the yuan is, in sum, precisely the wrong policy to advocate for any government interested in strengthening the global economy, eradicating demon inflation, and raising living standards, for such laudable goals can be achieved only through more, not less, international monetary stability.
China's export advantage will last as long as its labor costs remain low. These costs should rise, though, as the ratio of investment capital to labor capital increases, because greater automation and enhanced productivity typically leads to higher incomes and improved living standards. But that's in a free market. What will happen in China's hybrid capitalist-communist system is a matter of conjecture.
Even if Chinese officials were of a mind to acquiesce on revaluation, it's hard to see how much tighter China's central bankers could be without causing serious economic damage. In March, M1 money supply grew at a year-on-year rate of 10.4 percent and M2 rose at a 14.2 percent rate, while currency in circulation (M0) expanded at a rate of 10.1 percent. Although these rates of monetary expansion might seem lavish, they're actually quite appropriate, given the vast dimensions of China’s somewhat pell-mell transition to quasi-capitalism and the rapidity of growth in GDP and industrial production.
There is nothing left to add, save for the suspicion that the US are trying to inflate their way out of the staggering amount of debt they have accumulated in the last four years. A floating exchange-rate has proven very effective for this in the recent past. Euro-based investors have seen their dollar holdings melt down to 55 percent of the original value 4 years ago. It is more than understandable that China does not want to repeat such costly experiences. And don't forget, the one who holds the trumps (assets and goods) is China.
UPDATE: The US Treasury seems to pull back its claws again, as this report from Reuters tells. Referring to a Treasury spokesman, the Treasury will not speculate about the schedule about achieving a more flexible Yuan, it was said after a meeting between Treasury secretary John Snow and Chinese central bank officials in Washington. There is no set date for a next meeting which shall take place later this summer in Beijing. It seems the Chinese hold the trumps firmly.


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