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Strategies & Market Trends : China - The Next Great Stock Market ? -- Ignore unavailable to you. Want to Upgrade?

To: Stephen O who wrote (46)	1/12/2003 8:11:56 AM
From: Condor	Respond to of 140

China: Say No to RMB Revaluation Andy Xie (Hong Kong) RMB revaluation would worsen China's deflation and depress its domestic demand, in my view. With a large amount of surplus labor, China's competitiveness would be restored through a nominal wage decline (see "Yen vs. Yuan," Global Economic Forum, November 26, 2001). RMB appreciation wouldn't ease deflationary pressure elsewhere in East Asia at all. Instead, currency appreciation and wage declines in China would merely destabilize East Asia. A stable RMB is in the best interest of East Asia and the world., in my opinion Of course, China must allow the market to determine the value of its currency at some point. We believe this is possible only when China's capital account is mostly open. This wouldn't be possible, I believe, if China's financial sector remains state-controlled. China is adopting a gradualist approach toward financial reforms. It could be five years away before China's capital account becomes fully open, in my view. China is outperforming other Asian economies in export. This isn't new. Between 1987-97 China's exports grew eight percentage points faster than Taiwan's and by 5.4 percentage points faster than Korea's (see Exhibit 1). This gap widened to 9.6 and 7.2 percentage points, respectively, between 1997-2001. What is taking place is perfectly consistent with comparative advantage. China is a latecomer to globalization and is growing faster to catch up. Exhibit 1 Export (YoY % change in dollar) China Taiwan Korea 1987-97 16.6 8.6 11.2 1997-01 9.8 0.2 2.6 Jan.-Sep. 02 19.1 5.1 2.9 Source: CEIC The difference is that China's export base is much higher than before. After two decades of fast export growth, China's export base is significant and accounts for 4.5% of global trade today. More significantly China roughly accounts for one-fifth of the global trade increase on the margin. Thus, China is exerting more palpable pressure on more established players in global trade. Further, China's vast surplus labor has kept its wages low despite of its export success. China's nominal wages measured in US dollars have grown at about the same rate as in the US. One would expect China to have much higher wage increase. The culprit isn't an artificially depressed currency, in my view. I believe China's usual large surplus pool is the fundamental cause. China's labor market is among the most flexible in the world. There is little rigidity to wage adjustments in either direction. The starting salary for college graduates appears to be declining this year. The average time for locating a job has also lengthened substantially. Despite its export success China is still growing at a pace substantially below its potential. Because trade has become so large in China's economy, global demand determines China's wages. If RMB appreciates, it would depress global demand for Chinese goods and, thus, labor. That would translate quickly into downward pressure on wages. Chinese wages measured in US dollars would decline to reflect global demand for Chinese labor. The exchange rate is simply not powerful enough to artificially prop up wages in China. In terms of foreign exchange reserves China doesn't stand out at all. It is rising in line with trade, while it is rising much faster than other East Asian economies relative to trade. The absolute level relative to GDP is also lower than that in most other East Asian economies. If one wants to use foreign exchange reserves as an argument for RMB revaluation, it doesn't really work in the Asian context. Exhibit 2 Forex Reserves Forex Reserves (% of GDP) (% Increase, Jan.-Sept. 02) China 22.3 21.9 Hong Kong 0.0 67.7 Taiwan 55.5 28.5 Korea 26.0 13.3 Singapore 93.4 6.4 Source: CEIC Ethnic Chinese economies all have large forex reserves in US dollar assets. This is a far more complicated issue than just exchange value. The US dollar holds a special position among ethnic Chinese populations due to its historical track record as a safe haven for wealth preservation. Also, the US superpower status is reinforcing demand for US dollar among the ethnic Chinese population. When uncertainties rise, demand for dollars among ethnic Chinese tends to rise quickly. Hence, monetary authorities in these economies must hold sufficient dollars to match the domestic liquid asset base. The best measurement in that regard is the foreign reserves to GDP ratio (see Exhibit 2). Further, capital controls have artificially depressed dollar demand in China. In Hong Kong and Taiwan private holdings of dollar deposits exceed their foreign exchange reserves. In China this ratio is still 50%. There is nothing wrong with China selling cheap products into the global market, I believe. China stayed on the sidelines for more than a century, while many others industrialized. Japan and the West took advantage of China's lack of competitiveness and accumulated substantial amounts of wealth in China trade during the 19th century. China is now gaining back in competitiveness and accumulating some wealth as a result. The wealth accumulation in China is still small relatively to that of the global economy. Chinese households have accumulated one trillion US dollars in bank deposits. This is pretty much the bulk of the wealth that the Chinese have acquired through toiling in the global economy for 20 years. This compares to more than $80 trillion in net household wealth in the West and Japan. Chinese consumers are simply too poor to live off their wealth. They must work and save in order to be like their counterparts in developed economies. RMB revaluation certainly could be bad for China but is also destabilizing for East Asia and the global economy, in my view. Worsening deflation in China will depress its demand for goods from other East Asian economies. Its deteriorating labor market could endanger its social stability. A stable China has been beneficial to everyone. Risking it is not in anyone's interest, in my opinion. morganstanley.com