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China's Currency Strategy Could Backfire on Beijing

Tuesday, 22 June 2010 12:34 PM Current | Bio | Archive

Beijing’s attempt to throw sand in the eyes of the world with its announcement of expanded yuan (CNY) flexibility is set to backfire.

It isn’t 2005 all over again, as this time around the world is “demand-deficient.”

Minimal yuan appreciation is unlikely to be acceptable when the U.S. recovery could peter out later this year. We already fear a double dip in housing, while Europe will probably be slipping into recession again, at the latest in 2011. It will also mean a sharper domestic correction in overheating China.

A meaningful revaluation of the yuan against the dollar would have helped to avoid the resurgence of trade protectionism. Allowing the yuan to float and opening China’s capital account would have provided the least painful way of rebalancing the global economy.

Beijing’s deeply engrained belief in capital controls and managing the exchange rate as a way of maintaining control over the domestic economy while keeping external influences at bay rendered the latter option highly unlikely.

China’s sharp overheating in response to its massive monetary stimulus suggested Beijing may consider a higher yuan beneficial in curbing rising domestic inflation. Before such a view could take hold, Europe’s debt and economic malaise played right into the hands of Beijing’s mercantilist attitudes to render the first option also unlikely.

The People’s Bank of China’s weekend announcement that it was “to proceed further with reform of the renminbi/yuan exchange rate regime and to enhance the yuan exchange rate flexibility” was aimed, at least as how I see it, at throwing a bone to the United States and the rest of the world and nothing more.

But please don’t misunderstand me.

The People’s Bank of China’s announcement should not be considered as a nonevent — it’s far from it.

I agree that it feels like a watered-down version of 2005, with Beijing shifting its stance to allow the exchange rate to move but this time warning against the possibility of much of a yuan appreciation.

In July 2005, it took two years before the yuan was up by around 8 percent against the dollar and it only rose 3.6 percent in the first year.

However, while the world economy was at that time in the middle of the borrower economies’ credit binge and world output growth held up for a while, this time the world still suffers from a serious deficiency of demand.

China’s current policy stance means that the United States will have to resort to import restrictions when it begins to dawn on policymakers that America’s recovery is unsustainable and set to start petering out by the end of this year.

Meanwhile, European Union’s policymakers’ insistence on cutting structural budget deficits in the face of a painfully needed private-sector adjustment and tight monetary conditions has destined the whole of Europe to enter into recession by 2011.

But unlike the dollar, the euro could adjust against the yuan and has indeed come down sharply. Even so, China’s relentless fight to keep gaining world export market share will grate.

In my opinion, unless there is a fundamental change in China’s mode of development, it will be difficult to see the world not slipping into increased protectionism and every country and union having to fend for itself.

Even the “Great Recession” and China’s decisive domestic demand recovery were not able to do more than cut China’s current account surplus to 5.8 percent of GDP in 2009 from a peak of 10.6 percent of GDP in 2007.

And what’s even worse is when most people don’t see it that way.

The latest Chinese trade data show that their trade surplus is yet again on the rise as export growth forges ahead. The immediate problem for Beijing is cyclical.

The economy is overheating at a rapid pace and needs to cool down. A higher yuan would have helped to curb inflationary pressures, with no need to hammer domestic demand. Instead, not only is the yuan unlikely to be revaluated significantly, but policymakers have been slow in tightening monetary policy.

Consequently, China’s needed domestic-demand correction will be that much larger and that much more destabilizing as inflation has been allowed to gain more traction.

As investors who have to take into account the values of the world’s two main currencies, the dollar and the euro, we should not overlook the fact that China will be unwilling to imperil the fortunes of its export sector already struggling with a sharply weaker euro. Speaking of which, given the potential implications for China’s reserve growth and diversification, we should also consider the possible impact of Saturday’s announcement upon the euro.

In the three years that preceded the yuan’s 2.1 percent revaluation in 2005, China’s currency reserves grew by around $500 billion, whereas in the three years afterwards, its reserves grew by more than $1.1 trillion.

In other words, China’s reserve accumulation accelerated, in part as the revaluation itself stoked expectations of the currency’s continued ascent.

On this basis, if we were to suddenly revert to a pre-crisis world, then we would have little hesitation in calling for a stronger euro via healthy risk appetites and the reserve diversification activities of the State Administration of Foreign Exchange — SAFE.

However, the two periods are separated by more than time: not only may coordinated and in many cases, draconian policy tightening take its toll upon risk appetites in the months ahead, but there seems little end in sight to the euro zone’s sovereign risk crisis, which has dealt a serious blow to the status of the euro as a reserve currency.

No doubt in my mind that China will therefore further accumulate more dollars as the euro is no longer in prime position to benefit and no safer a store of value than it was last week.

If the euro/dollar were to advance further from here on, my inclination to sell would begin to rise commensurably — and certainly were the euro to approach $1.2645.

China has just tightened economic policy, after all.

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Beijing s attempt to throw sand in the eyes of the world with its announcement of expanded yuan (CNY) flexibility is set to backfire. It isn t 2005 all over again, as this time around the world is demand-deficient. Minimal yuan appreciation is unlikely to be acceptable...
Tuesday, 22 June 2010 12:34 PM
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