Global Intelligence Update
August 14, 1998
Chinese Insistence on Supporting the Yuan Masks Deeper Problems
As the Russian financial system crumbles, the focus of international
attention must remain on China. With Russia's economic future fairly
clear, the remaining major question in the global economy is whether and
how long the Chinese will manage to hold the line. The pivotal question
has become the future of the yuan. With the collapse of the rest of Asia's
currency structure, it would have seemed inevitable that China would be
forced to devalue its currency as well, in order to maintain a rough
competitiveness in the price of its exports. However, the Chinese
government has not only refused to devalue the yuan, but has made the
currency's defense a fundamental policy objective. Thus far, they appear
to have succeeded.
Appearances can, of course be deceiving. The yuan has already declined.
According to the Hong Kong newspaper "Ming Pao," the black market price in
of the yuan has fallen to 8.9 to the dollar, as compared to the official
rate of 8.6. This represents a decline of about 3.5 percent. Since the
Yuan is a controlled currency, there is a normal discount between the
street price and the official rate. But the rates began to gap last week,
amid rumors that the Chinese government would devalue the yuan in relation
to its coal exports. This rumor helped create the gap, since a partial
devaluation is hardly sustainable. The gap continued to widen, clearly
alarming the Chinese government.
In response to this, Beijing kicked off a vigorous campaign to stabilize
the yuan, issuing strong warnings to speculators. Officials reminded them
of the strength of the Chinese economy and of the willingness of the
Chinese government to defend the yuan. Liu Mingkang, deputy governor of
the People's Bank of China, warned speculators not to "bet" against China,
which he said still holds $140 billion in foreign exchange reserves. Hong
Kong's financial secretary warned that speculators attacking the Hong Kong
dollar would be similarly smashed, noting that the mainland's currency
reserves will defend the HK dollar. The Chinese ambassador to Tokyo took
up the cry as well. This warning was urgently repeated by other officials
and in the Chinese media in an orchestrated campaign.
One interesting question is who this warning was directed at. The yuan is
not traded on highly liquid markets, so arbitrage masters like George Soros
are hardly going to raid it. The mechanisms for a major move simply aren't
there. The real targets for this barrage of reassurances was not foreign
speculators but domestic Chinese, who have been scrambling to buy hard
currencies in anticipation of devaluation. Earlier this month, new
regulations were put into effect which stated that Chinese financial
institutions would have their operations suspended if they permitted
customers to illegally purchase foreign currency. Chinese citizens need
government issued permission to purchase and hold foreign currency.
The mystery here is: Why is the Chinese government waging an international
campaign to convince its own citizenry not to dump the yuan for dollars?
Given control mechanisms, foreign speculators can't force the yuan down
without the government's agreement. Speculators are not the major force in
the black market. So issuing statements in Tokyo is fairly pointless.
Vigorous enforcement of currency laws should be enough. Yet, facing a
domestic problem, the Chinese government is conducting an international
campaign.
Explaining this strange behavior requires us to consider a broader oddity.
What is the big deal in devaluing the currency? With the rest of Asia's
currencies slashed, devaluing the yuan would seem a logical and prudent
move. After all, China is an export oriented economy and the artificial
inflation of its currency relative to its competitors' and markets'
currencies places China at a disadvantage. Indeed, the Bank of China vowed
last week to increase its support of exports with favorable financing
arrangements, because China needed foreign trade to grow this year by 10
percent. Now, if that is the goal, then refusing to devalue seems not only
strange, but counterproductive. Again, what is the big deal? Chinese
explanations, including fear of inflation and a fear of weakening the rest
of Asia simply don't explain the refusal for even a modest readjustment in
currency levels.
So, we have two facts. First, the Chinese government is doing everything
it can to convince non-Chinese that China is not going to permit the yuan
to decline, in spite of the fact that foreigners have relatively little
influence over that decision. Second, the Chinese unwillingness to devalue
runs counter to the export obsessed Chinese economic strategy. Why defend
an arbitrary value for your currency when it will undermine your core
economic strategy? And why is China trying to convince foreigners that it
will not change a clearly counterproductive policy.
At the core of their argument is a key assertion, made over and over again,
that they hold $140 billion in foreign currency. It is this claim that
convinces the world that China will float above the Asian disaster. It is
this assertion that encourages U.S. companies to continue investments in
China; to continue to finance Chinese commercial paper that is dollar
denominated; that allows non-Chinese to do dollar denominated business with
China. If that claim is false, then the infrastructure of Chinese export
trade will begin to evaporate.
China is desperately trying to convince outsiders of its reserve level, not
because of its currency concerns, but to persuade them to continue carrying
out dollar denominated trade. The current campaign has little to do with
the yuan and everything to do with the claim of massive reserves. Yet
reports in the past two days report the Chinese selling yen fairly
intensively, in spite of its depressed price. We think this has less to do
with the Chinese evaluation of the yen and more to do with the need to sell
foreign currencies in order to cover debts.
In other words, we are not at all convinced that China has reserves of $140
million. We do not know the true level of Chinese reserves, but we do know
that the universal characteristic of the Asian crisis is that government
claims on currency reserves, on banking liquidity and on bad loans and so
on, have in every case proven to be false. We see no reason to believe
that China is the exception. Indeed, China is perhaps the least
transparent and least regulated banking system. We don't think that the
Chinese have anywhere near $140 million in reserves. If they did, they
would ignore speculators, they would carry out a modest devaluation, and
they wouldn't give it a second thought.
We are becoming convinced that the Chinese are attempting to convince
foreigners that they are in better shape than is actually the case in order
to maintain the trade facilities they desperately need to maintain their
economy's stability. Bellicose threats, inflexible currency policies,
unrealistic growth targets, and obsession with exports even at losses, do
not add up to the image China is trying to project. Countries with $140
billion in hard currency reserves don't behave inflexibly. Countries in
financial trouble, trying to convince outsiders that there are no problems,
do behave this way. That's why they are cracking down on every citizen
holding foreign currency. Not because they are rolling in money, but
because they are running out.
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