China: Forget About a Currency Policy Shift
The yuan will only appreciate mildly in '07, says Standard Chartered's Stephen Green, as long as inflation stays low and Beijing reels in the cash
businessweek.com.
by Stephen Green
In the summer of 2005, an intense political debate over Chinese currency policy came to a head in Beijing with Premier Wen Jiabao signing off on a 2% one-off revaluation against the U.S. DOLLAR, followed by a 3% appreciation over the following year. Eighteen months later, the yuan has strengthened a total of 5.6% against the greenback. (It has weakened against the euro, but that is not so important for most Chinese firms that invoice in DOLLARs.)
Standard Chartered thinks the yuan is still on the same trajectory in 2007 and will appreciate only 3% to 4% this year against the DOLLAR. That will take us to a rate of 7.5 yuan against the DOLLAR by the end of this year, from 7.8 today. Until the debate intensifies again, we think Premier Wen's decision will stand. And to be honest, the debate, though it rolls on in Beijing, is not all that intense.
It would take a serious revival of inflation in China or some seriously aggressive legislation (rather than threats of it) from the U.S. or Europe to change the current go-slow approach by Beijing financial authorities.
Liquidity vs. Slowdown
In fact, when one looks at today's China, the problems associated with an undervalued exchange rate and a whole host of other tax policies which promote exports do not appear that critical. Sure, the country is flooded with liquidity as export receipts and other flows enter, interest rate independence is limited, and Washington continues to fume. However, these are not obviously more damaging than the sharp slowdown of job creation in the export sector that a much faster appreciation of the yuan might engender.
Of course some of the problems are not that easy to spot. Take for instance the low interest-rate environment. For an economy growing at more than 10% a year in real terms, real lending rates should be nearer 10% than the current 2%. But because of central bank fears of higher onshore rates attracting even more foreign capital into China, rates are kept low. And this explains the lending boom and why bank capital is less efficiently allocated than it should be.
The People's Bank of China (PBOC), the nation's central bank, is also caught in a difficult place on the exchange-rate question. It has been at the forefront of those arguing for greater currency flexibility and warning of the consequences (excess investment, inflation) of postponing reform. And it has the laborious task of "sterilizing" a chunk of the $1 billion to $2 billion that enters the country each day in order to prevent that money getting added to the domestic money stock and thereby stoking inflation.
Happy With Status Quo
But at the same time, they are doing very nicely thank you from the current arbitrage between China's artificially low rates and higher ones overseas. Central banks are not in the market to make money—far from it. Indeed, the PBOC's two primary missions—to maintain domestic price stability and defend a stable exchange rate—mean that it sometimes has to spend money.
However we estimate that it actually made $29 billion worth of profit in 2006. So while other central banks would be screaming bloody murder when tasked with defending an undervalued exchange rate and having to spend money to defend it, the People's Bank has the opposite problem. In its head, it knows that the yuan and domestic interest rates are too low, but its wallet is more than happy with the current status quo.
To work out how the PBOC made money in 2006, Standard Chartered looked at both its spending and revenues. First off, yuan appreciation undermined the domestic-currency value of some of China's foreign currency reserves. This is because an appreciating yuan devalues its foreign currency reserve assets vis-á-vis its liabilities (primarily the money it issues in China), which remain denominated in local currency.
Grand Total Payments
At the start of the year, the central bank had $573 billion in U.S. DOLLAR assets, and the yuan appreciated 3.2% against the greenback over the year. That means the yuan value of those assets declined by 3.2%—or by $19 billion in DOLLAR terms. However at the same time the yuan depreciated in value against the strong euro by some 8% over the same period. So the 20% of the foreign currency reserves we assume was in eurobonds at the start of 2006 would have increased in value to the tune of $16 billion. Overall, then, the central bank shouldered a balance-sheet loss of $3 billion.
Two outflows of money must be considered. The PBOC has to pay banks for the reserves they hold at the central bank. Though that isn't a huge burden given China's low interest rates, it cost the central bank $6 billion last year. Then there is the interest tab on the bills the central bank issues to investors. That came to about $5.5 billion in 2006. So if you consider the balance-sheet hit, reserve, and interest payments, the grand total comes to $15 billion.
Now consider the central bank's income. We estimate that at present the PBOC rakes in about $4 billion a month on its overseas investments in U.S. Treasury Bonds, eurobonds, and other securities. For all of 2006, it probably received roughly $44 billion in interest payments. Do the addition, and you get to our estimated $29 billion profit for China's central bank.
Another Big Year
So what's the upshot? In one sense, whether the PBOC makes or loses money factors very little into the China leadership's thinking on currency policy. However the interest-rate gap between Chinese and U.S. rates is sure to continue in 2007. As long as that is the case, the cost of managing China's undervalued currency is zero, though a blowout in the money supply, and inflation, are always risks.
Yet that's not happening now. So the economic incentive of pleasing China's irate trading partners with a sizable appreciation of the yuan is quite low. For all these reasons, one should expect only modest appreciation (in the 3% to 4% range) in the yuan—and yet another year of gargantuan Chinese trade surpluses in 2007.
Green is a senior economist at Standard Chartered Bank and is based in Shanghai.
From: RealMuLan 1/10/2007 6:39:36 PM
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