AN AMERICAN ULTIMATUM
by Mark Tier
dailyreckoning.com
After years of American pressure on China to revalue its currency, the
yuan,
Congress recently threatened to impose a 27.5% tariff on all Chinese
imports
within six months if China doesn't revalue - or float - its currency.
A revaluation would give speculators who'd bought yuan an instant - and
guaranteed - profit.
Let me explain. Since 1996, the Chinese yuan has been fixed at a rate
of 1 yuan
= 12 US cents. If the yuan was revalued it would be worth more ... say,
15
cents.
And since this will be a new fixed rate, the government of China would,
in
effect, be committed to giving 15 cents to each person who'd bought
yuan at 12
cents.
Sounds like a good deal for buyers of yuan, right?
Apparently, currency speculators around the world agree: in 2004 $1.2
trillion
in "hot money" poured into China, China's foreign exchange regulator
said
recently.
Before you rush in to join the crowd, there are two questions you
should have
answers to. First, will China revalue the yuan? If so, when, and by how
much?
Let's take the second question first.
The answer to this question is simple: nobody really knows. Say China
revalued
the yuan by 10% two years from now. That would give you a 5% per annum
return
on your capital. Not very interesting. (And nor would it satisfy the
Americans.)
Of course, it could be more, and it could be sooner. But whatever it
turns out
to be, the ultimate profit is uncertain.
If there is to be a profit...
A major attraction of buying yuan is the general assumption that
there's no
downside risk because there's only one way that Chinese currency can
go: up.
But is this true?
To answer that question, imagine you're president of China's central
bank. You
have some choices. You could do nothing. You could revalue the yuan.
You could
devalue it. Or you could float the currency, so its exchange rate would
be set
by the free market instead of government fiat.
Looking at the economic data, it's hard to find anything that would
justify a
revaluation. For example, according to a Federal Reserve Bank of
Cleveland
analysis, in the 10 years the yuan has been fixed to the dollar, its
real value
has actually fallen against the greenback - if only by 2.4%. That
implies it's
really worth less than 12 cents.
Secondly, that $1.2 trillion inflow of "hot money" that I mentioned
above, when
converted into yuan, has caused China's money supply to explode. It was
up
14.4% last year, compared to and increase of just 2.7% in the United
States.
What's more, in the past six months, as Alan Greenspan has tightened
the
screws, the supply of dollars (using the M1 measure of the money
supply) has
actually declined.
While Chinese yuan have become more abundant, dollars are actually
getting
scarcer! You don't have to be an economist to figure that the dollar
should
rise in value, and the yuan should fall.
So, as president of the central bank of China, faced with this American
ultimatum, what are you going to do?
Obviously, you can't devalue the currency. That's out.
Ideally, you'd probably prefer to do nothing. That's usually the safest
bureaucratic path.
Perhaps you could try and persuade American politicians that their
demands are
illogical. But logic is a poor tool to use with people who are blinded
by their
emotions and politics.
You could give in to the American demand, and revalue the yuan by some
amount
that would satisfy them. Probably in the region of 25%.
The very next day, however, the speculators would all be knocking on
your door,
wanting to turn the yuan they bought for $1.2 trillion back into
dollars at the
new, higher rate: you'd have to pay out $1.5 trillion.
The speculators' $300 billion profit would come straight out of your
foreign
exchange reserves. Better to let the Americans impose their tariff.
After all,
that wouldn't affect Chinese exports to the rest of the world; and
you'd keep
your foreign exchange reserves intact. (In any case, most Chinese goods
would
STILL be cheaper than the alternatives - even with the tariff!)
What about letting the yuan float free?
Since most everybody seems to think the yuan is undervalued, there
would
probably be a rush into the currency, which would send it up.
But very quickly, speculators who are already there will start to take
their
profits, pushing the yuan back down. That could easily trigger a rush
for the
exits, sending the yuan into freefall.
Worse, a collapsing yuan could easily expose the serious weaknesses of
China's
banking system, sparking an economic crisis the fixed exchange rate was
designed to avoid.
Frankly, I have no idea what the president of the central bank of China
is
going to do - and I'm very thankful that I'm not in his shoes. But I
imagine
he'll move Heaven and earth to avoid giving speculators a $300 billion
profit.
One thing, though, is clear: as is usually the case in the markets,
what seems
to be a "sure thing," with a guaranteed profit and no downside risk, in
reality
has a return somewhere between zero and something, with a very high
chance that
you could lose a bundle of money.
So unless you're George Soros, and currency speculation is firmly
within your
"circle of competence," probably best to leave this one right along.
That's
what I'll be doing.
Regards,
Mark Tier
for The Daily Reckoning |
