CHINA TO U.S.: STOP BULLYING US NOW AND HERE
by Toni Straka
PrudentInvestor.Blogspot
May 23, 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 figures. 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 even appreciated on the website of the National Review, a forum of dyed in the wool conservatives. 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.
On May 10 the US Treasury pulled in its claws again after a meeting with Chinese central bank officials. According to a Treasury spokesman, the Treasury will not speculate about the schedule about achieving a more flexible Yuan. 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.
History shows that currency disputes always got settled by the markets - in the end
Time-travelling from the old Greeks to the Roman empire, to the British empire and then the young history of the USA one notes that the most widely accepted (reserve) currency always had its homebase in the political powerhouse of its times. The political power always footed on three determining factors: The productive capacities of that nation, its international trade relations and its capability to defend itself.
While there were several denominations of silver coins in circulation in the Greek empire that had their origin in the provinces of Byzantine, Macedonia and Peloponnesia, to name just a few, the Roman empire first introduced the silver drachmae in order to facilitate trade with the Greeks. The drachmae was followed by the golden aureus, the silver denarius and the bronze sestertius. One aureus was equivalent to 25 denarii or 250 sestertii.
Inflation was the beginning of the end of the Roman empire
The aureus had a respectable lifespan of more than 400 years before inflation diminished its reputation. Nothing has changed since: Whenever a currency loses its value, so does its popularity.
First the Roman emperors started chipping away on the edges - this resulted in the grooves on its edges, still seen on many current coins in circulation - and then the purity of the coins was tampered with until they became pieces of lead covered by a thin coat of gold plating. As the Roman empire declined, so did the Roman money as a means of tangible form of payment for goods and services. In medieval times all forms of money and their respective strength were mainly tied to its content of precious metals. A system that held up to World War I. One Swiss gold franc had the same value as one Austrian gold crown or a Dutch gold coin of the same weight. There was no need of a Bretton Woods agreement in these times.
The reserve currency of the 18th and 19th century was undoubtedly the British pound sterling. As the name says, a one pound note could at any time be redeemed against one pound of sterling (pure) silver at the Bank of England or before that at the treasury of the king. The sixpence stems from the custom to cut a silver penny in six equal pieces for small purchases.
With the demise of the British empire which went hand in hand with the outsourcing of its productive capacities to the colonies where labour was cheap, the pound was replaced by the US dollar in the early 20th century when the US ascended to the throne of the biggest producing economy in the world, a place it has held since.
A paper of professors Menzie Chinn (University of Wisconsin) and Jeffrey Frankel (Harvard University) for the NBER conference on coming June 1st, looks at the next 20 to 30 years and concludes that "under any plausible scenario the dollar will remain far ahead of the euro and other potential challengers for many years."
I wonder whether this western approach will still be valid in 30 years from now. Under the assumption that the European Union with its strong productive base and its highly developed financial markets - especially once Britain joins the Euro - will come back to the path of stronger growth again the Euro could climb to the number one spot in the line-up of international currencies.
Euro will lead only for a transitory period
But this might be for a transitory period only. Most forecasts see China becoming the biggest economy on the globe by 2020, give or take some setbacks on the way to there that are inherent with such growth rates that this country has been enjoying recently.
China still buys time on the way to a liberalization of its currency controls, not least for the reason that its financial sector is still in its infancy, China will also develop this sector and gain knowledge on that way. With a consumer base of probably more than 1.5 billion people by then it has a huge backyard on which it can rely for further growth for its growing international importance. As the country has been on the path to a more liberalised economy for the last 15 years, taking one step at a time, its careful planning of the future will lead to a more prominent role in the capital sector. Those who produce can save too and therefore become a supplier of capital needed elsewhere.
Of course it is premature to speculate about the Yuan becoming the reserve currency of the world.
But it is not premature to speculate when the resource-rich countries will begin to favour the Euro as the preferred means of payment for the riches in their soil. Until now commodities are predominantly priced in dollars on the world markets, stemming from the fact that the US are the single biggest buyer and consumer of energy and have been the biggest buyer of most other commodities. In an age of global redistribution this might change as the US have given up their number one rank as a purchaser of other commodities.
Staying with dollar based prices could become a too costly way for others to conduct their bilateral trade with the currency of a third country that is primarily known for its huge amount of debts and no plausible recipe for a turnaround of this situation. After outsourcing its production an outsourcing of control of international trade could be well on its heels for the US.
The race for financial dominance is on. And it will be decided in favour of the country or region that manages to maintain a lead in production which will inevitably located in proximity to the world's largest base of consumers.
If you want to read more about the transitoriness of currencies, follow this link.
China will take its time for the reform of its currency controls and will not give in to any outside pressure. Responding to last weeks aggressive comments by the Bush administration, requesting a quick revaluation and threatening China could be branded a manipulator of currency, China stood up and basically said, stop bullying us. Reuters reported that "Chinese Vice Premier Wu Yi said on Monday that China remains committed to reforming its currency but no timetable has been set for when the reform will take place. 'We will not reform the yuan until the time is right even if there is external pressure. As for when to reform the yuan, there is no timetable yet,' she said, adding that the county is fully committed to such reforms.
A revaluation of the Yuan hinges on the success of China's efforts to shore up its ailing banking sector. China's banking system is burdened by non-performing loans (NPL) amounting to 1.83 trillion yuan or 220 billion dollars, the China Banking Regulatory Commission (CBRC) last week. This amounts to 12.4 percent of all outstanding loans. China has been trying to improve risk controls and corporate governance at its banks, many of which are looking for tie-ups with overseas banks and listings as part of efforts to become sound entities capable of taking on growing competition. A revaluation of the Yuan would make these NPL's more costly to any potential investor in China's banks.
Overheating economy may lead to higher inflation
China's rapid growth in excess of 9 percent annually meanwhile rises the eyebrows at the Asian Development Bank (ADB). According to chinadaily.com ADB's senior economist Zhuang Jian said 2005 would be key to the stable and sustainable development of China's economy and macro-control policy should continue to cool down the economy. "The continuous three-year GDP rate over 9 percent will lead toa 5-plus percent rise in consumer price index (CPI), which most residents cannot bear," Jian said.
Currently Chinese enterprises and local governments are still very eager to invest, and the inflation pressure is enormous, he said.
Fixed asset investment in China's urban areas went up by 25.7 percent year-on-year in the first four months this year, according to China's National Bureau of Statistics.
© 2005 Toni Straka
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