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Thesis & Antithesis

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greekdefaultwatch@gmail.com Natural gas consultant by day, blogger on the Greek economy by night. Trained as an economist and political scientist. I believe in common sense and in data, and my aim is to offer insight written in language that is clear and convincing.

29 July 2005

China revalues currency

On July 21, the People’s Bank of China announced that it would adjust its policy of pegging the Yuan to the dollar; the Yuan was revalued by 2.1%, whilst a 0.3% band would be maintained on either side. The governor of the central bank called it “an initial adjustment,” while there was also talk of moving towards a managed float, perhaps with a basket of currencies.

What is obvious is that this change will have little net effect on the balance of payment crises looming in the global economy—America’s twin deficits or China’s current account surplus, projected at 6% of GDP for 2005 (1). But the move is indicative of changes to come, changes that could have a significant impact on the global economy; however, it is those underlying changes, rather than any move in the exchange rate, that people should pay close attention to—particularly Beijing’s obsession with export-led growth.

To begin with, the revaluation shows that China bows to pressure—it hardly escaped Beijing’s attention that in April 2005, “67 Senators gave initial backing to a measure sponsored by senators Charles Schumer and Lindsey Graham that would impose a 27.5 per cent tariff on all Chinese imports unless Beijing revalued within six months” (2). But as Robert Samuelson of the Washington Post commented, “China apparently hopes that its revaluation will appease angry US congressmen and derail legislation that would impose steep tariffs on Chinese imports” (3).

All the same, the diplomacy of the US Treasury was eager to stress that it was in China’s interest to adjust the Yuan, rather than emphasize its importance in addressing America’s economic woes; “we wanted to try … patient and private diplomacy rather than an international battle,” said Tim Adams, former chief of staff to Treasury Secretary John Snow (2). This too was the tone of the People’s Daily, Beijing’s official party newspaper, whose headline read, “RMB exchange rate reform—decided out of China’s own need” (29 July 2005).

Following the revaluation, it is likely that the market pressures on the Yuan will increase as investors bet on a further revaluation, causing an influx of hot money into China (4). This is a prospect that China, like other developing economies, fears; in fact, Princeton economist Paul Krugman thinks that China ended up with the peg to protect itself from the 1997-1998 Asian financial crises and refused to meddle with the system after that because the economy was doing well (5). This a fear articulated by Zhou Xiaochuan, the central bank governor, in this (curious) metaphor:

“A fixed exchange rate is like a shield in the hand when fighting, however you attack me, I will remain unmoved; if I fail to hold on, the impact will cause influence. A floating exchange rate is like a foam-rubber cushion, if you want to fight your way in, I'll react softly, ok, you've come in, but I won't let you hit me; when you want to quit, I'll give you a pinch and let you go only after you have taken a layer of your skin off” (6).

At the same time, China might forgo some of the stabilizing benefits of a pegged exchange rate. China was essentially adopting America’s monetary policy: “China’s rate of inflation in its CPI [Consumer Price Index] has converged to that in the US, at a low level of about 2% a year” (7). Even more, its stable currency has accorded the predictability that encourages Foreign Direct Investment and has allowed other East Asian economies (save Japan) to maintain a relatively stable currency against the dollar (7). Even more, a steep rise in the value of the Yuan could undermine the Chinese economy, whose growth is primarily driven by exports, and which “some officials say requires a 7% growth rate to create enough jobs to maintain social stability” (2).

But the most important theme that emerges from the Yuan revaluation is the perversity that is the global economy. America’s current account and trade deficits mean trouble in the near future, while China’s economic policy also spells trouble; as Mr. Samuelson wrote, “The central problem of the exploding trade imbalances between China and the United … is the addiction of China, following the pattern set by Japan and other Asian countries, to export-led economic growth” (3).

China is engaged in a perverse economic policy. Essentially, China lends money to America so that American consumers can purchase Chinese goods (which also allows the American government to finance its own budget). This is caused by two economic realities—the low savings rate in America (about 2% of household income; ref. 8), and the high savings rate in China (40% GDP, 25% of household income; ref. 2).

This means that China’s currency policy is a substitute for a serious reform of its own banking and finance system—instead of investing this money in its domestic economy, it is lending money abroad. As Mr. Krugman noted, China “is devoting a lot of resources to the accumulation of basically useless pile of dollars instead of to higher living standards” (5). In other words, instead of lending money to its own people to buy goods, it is lending money to Americans; this adds to a long history of government failures in the region to stimulate domestic demand (9).

But China’s high savings rate indicates a more profound structural failure; China’s savings offer a huge pool of low-cost capital for investment. However, as the Financial Times notes, “it is invested inefficiently: to increase economic output by $1, China has to invest $5, a very high ratio by international standards. That is largely because its banks are still struggling to modernise and are plagued by corruption and fraud” (2).

Insofar as the move is a step towards correcting this absurdity, it should be welcomed; “Andy Rothman of CLSA, the Asian investment banking arm of Crédit Agricole, argues that Beijing probably views last week’s changes primarily as a useful step in learning how to manage a more flexible currency regime, rather than as a response to macroeconomic imperatives” (2).

Overall, this move is unlikely to have much an effect on America either because many will regard this change as too insignificant or because they will perceive it as evidence that China bows to pressure. But in this political talk of exchange rates, it is well worth remembering that exchange rates are merely numbers—numbers that capture essential truths about the relative value of economies; to focus on the exchange rate alone is to form economic policy that is both silly and wrong.

(1) Morris Goldstein & Nicholas Lardy, “China’s Revaluation Shows Size Really Matters,” Financial Times, 22 July 2005
(2) Andrew Balls, et al, “The US diplomacy behind China’s revaluation,” Financial Times, 24 July 2005
(3) Robert J. Samuelson, “China’s devalued concession,” Washington Post, 26 July 2005
(4) “If the PBC allows only small appreciations (as with the 2% appreciation announced on July 21) with the threat of more appreciations to follow, then hot money inflows will accelerate. If China attempts further financial liberalization such as interest rate decontrol, open market interest rates in China will be forced toward zero as arbitrageurs bet on a higher future value of the RMB. China is already very close to falling into a zero-interest liquidity trap much like Japan's – the short-term interbank rate in Shanghai has fallen toward 1%. In a zero-interest liquidity trap, the PBC (like the Bank of Japan before it) would become helpless to combat deflationary pressure.” Ronald McKinnon, “Currency Wars,” Wall Street Journal, 29 July 2005
(5) Paul Krugman, “China Unpegs Itself,” New York Times, 22 July 2005
(6) “RMB exchange rate reform—decided out of China’s own need,” People’s Daily, 29 July 2005
(7) Ronald McKinnon, “Currency Wars,” Wall Street Journal, 29 July 2005
(8) “The Great Illusion: Survey of the World Economy,” The Economist, 30 September 2004
(9) “But Asia's efforts to stimulate stronger domestic growth have usually failed. Japan has been struggling to do so for nearly 20 years. South Korea recently encouraged the spread of credit cards -- and ended up causing massive consumer loan losses.” Ref. 3



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