China: What Can
2% Do?
China¡¯s 2% appreciation has given both sides of the Rmb
(or Yuan) debate some crumbs to chew on. After two years of guessing
¡®when¡¯ and ¡®how much¡¯, the Rmb bulls can point to the fact that
something has happened and can conjure some scenarios calling for more gains
to come. The bears can point at just 2% for two years of hype. The
appreciation barely pays for the negative carry in the Rmb revaluation trade.
Most hedge funds have actually lost money, as their average
price is still above the new Rmb quote. China-based export companies, owned
mostly by offshore capital, have profited from the difference between onshore
and offshore Rmb prices by selling Rmb offshore and over-invoicing exports to
accumulate extra Rmb to square the position.
The 2% move has definitely eased the tension between China
and the US. Many influential figures in the US had staked their names on
forcing a change in China¡¯s exchange rate. Small though the move was, it has
saved face for these people, such that they should now be less worked up and
may stop talking about China¡¯s currency for a year.
Letting Out Some Steam
Many people have staked their names on forcing or
predicting a change in China¡¯s exchange rate in the past two years. Several
high-profile US politicians and Bush administration officials have staked a
lot of political capital on forcing a Rmb change. An overwhelming majority of
the pundits in the market had also rallied around the view that China¡¯s
currency would appreciate, partly to support the weak dollar call. Significant
amounts of local foreign currency assets and overseas Chinese money were
converted into Rmb and stayed in China¡¯s monetary system. Numerous hedge
funds even bought the Chinese currency in the offshore market at a substantial
premium and the money made its way into China via export companies
over-invoicing exports. I estimate the hot money may have totalled US$350
billion (see Hot Money Leaving, July 6, 2005).
After two years of eager anticipation, the situation was turning
ugly. It felt like the audience was expectant but the main act had failed to
show up. When China appreciated 2%, everyone had an excuse to let out some
steam. This was the most important function of this currency change, I
believe. International opinion towards China had turned largely negative in
the past few months because of the pent-up frustration.
The prolonged battle with China over its currency should
also serve a lesson to those who staked their names or political capital on
changing China, in my view. China is too big to be pushed around easily. In
the globalization game, Chinese are the minimum wage workers while Americans
have the most high-paying jobs. It is just difficult to ¡®punish¡¯ minimum
wage earners in today¡¯s world. This is why, I believe, the people who have
been very vocal about pushing China towards revaluation may be more cautious
in future. This would certainly help China manage an economy that faces far
more serious challenges than arguing over the value of its currency.
Some US politicians will keep this issue alive, I believe.
However, until the US economy shows serious weakness, which may happen 12
months hence, the pressure on China should remain below the boiling point.
No Impact on Imbalances
Movements, no matter how drastic, in China¡¯s currency
will have only a marginal impact on global or domestic imbalances, in my view.
China¡¯s domestic imbalance between investment/exports and consumption is due
to low wealth level and uneven income distribution. Currency appreciation or
depreciation is likely to have a limited or even a negative impact on this.
The vast US trade deficit is due to excessive consumption
on high property prices in the US. It cannot be solved by artificially raising
Chinese wages. But it can be solved if the Fed takes back the money that keeps
US property prices so high.
The US pressure on China, of course, has not been due
entirely to the belief that China¡¯s currency reform can solve its problem.
Rather, it has been due partly to the notion that China is growing too fast
and a stronger yuan may slow China down. Of course, China knows this and has
resisted the pressure. The 2% move will not buy off the people in this camp.
However, I expect it will convince most other commentators to move on.
Limited Currency Flexibility Ahead
China¡¯s priority is stability. Currency flexibility
should not be allowed to conflict with this goal, in my view. Given that China
is in transition, as an industrializing, and urbanizing economy with 300
million surplus workers, it faces immense challenges beyond the experience of
many in the west. It is extremely unlikely that China could tolerate
substantial currency volatility.
The euro and the yen are the major independent currencies
in the world. While Europe and Japan account for 36% of China¡¯s exports,
large shares of these exports (e.g. PCs and sneakers) are priced in the US
market. The true influence of these currencies over China¡¯s export
performance is limited.
It is early days to assess how flexible China¡¯s currency
will be. Daily flexibility of 0.3%, for example, would suggest that the basket
that China¡¯s central bank refers to is weighted heavily towards the dollar.
I suspect that, if the euro and the yen move by 1% against the dollar in the
same direction, China¡¯s currency could move by 0.3% or less compared to 36%
of China¡¯s exports to these two markets, because the prices of many exports
to these markets are determined in the US market.
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