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Interesting piece on China and its currency.


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*From:* Mark Zoff [mailto:markzoff@davidhaleweb.com]
*Sent:* Monday, June 21, 2010 10:29 PM
*To:* Mark Zoff
*Subject:* David Hale: How Swiftly Will China Revalue Its Currency?


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Additionally, please find attached our latest bulletin, “How Swiftly Will
China Revalue Its Currency,” which examines the background surrounding
China’s impending decision to revalue the renminbi and analyzes the key
factors that will determine the rate of the currency’s appreciation in 2010.


As always, we welcome any comments or feedback you may have.


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How Swiftly Will China Revalue Its Currency?

June 21st, 2010 • Volume 08.16

By David Hale


There are few issues which generate as much misunderstanding as China’s
exchange rate policy. Although many blame China’s trade surplus for the
large US current account deficit, the deficit is the result of America’s
savings and investment imbalance, and not China’s trade policy. When the US
invests more than it saves, it has an external deficit and must borrow
money. In the past, the US often had a current account deficit because of
low household savings and robust corporate investment. In 2010, both the
household and corporate sectors have high savings rates. The major imbalance
is the $1.6 trillion federal budget deficit. In the absence of this deficit,
the US would have a large current account surplus. China has signaled that
it will begin to tighten monetary policy soon, and the renminbi could
appreciate between 2-5%, or more, against the US dollar by the end of this
year depending upon the dollar’s performance against other currencies.


The US Congress is once again becoming agitated about China’s exchange rate
policy. In 2009, it could blame America’s economic problems on Wall Street.
In 2010, it needs a new culprit, and it is turning to China.


China established an exchange rate target against the US dollar during the
mid-1990s because of the need for a low inflation monetary policy, not
because of concerns about trade. In the early 1990s, China had a lax
monetary policy. The money supply rose sharply and inflation shot up 30%.
The government decided to establish an exchange rate target in order to
combat inflation. The exchange rate target gave China the same monetary
policy as the US.


China has enjoyed dramatic growth in exports during the past two decades and
displaced Germany last year as the world’s leading exporter of manufactured
goods. Such an achievement is impressive for a country which had little
foreign trade thirty years ago. China achieved this export success by fully
embracing the concept of globalization. It allowed foreign firms to invest
over $800 billion in the country and turn China into a manufacturing center
for their global operations. Foreign firms produce 60% of China’s exports.
This policy is in total contrast to Japan and South Korea. During the first
four decades after World War II, both countries tried to restrict FDI in
order to protect local companies. China’s FDI policy has made it a far more
open economy than Japan or South Korea have ever been. Foreign firms now
dominate the Chinese markets for autos, cameras, cellular telephones, soap,
and other consumer products.


China also has a high level of integration with East Asia which will limit
the ability of exchange rate appreciation to alter its trade performance.
China is an assembly shop for supply chains which run all over the world,
but which center on East Asia. Only 20% of the value added of Chinese
exports actually accrues to Chinese companies. The other 80% goes to
companies that supply components for assembly. The major suppliers of these
components are Taiwan, Korea, Japan, Malaysia, and other Asian countries.
During the past decade, there has been a decline in the American share of
trade with other Asian countries because of the role they now play supplying
components to China. The US trade deficit with Japan would be 25% higher if
Japan exported directly to the US the goods it now sends to China for
re-export to the US. The US Congress should recognize that any trade
sanctions on China would fall heavily on other East Asian countries and
Australia. There would have to be a revaluation of all Asian currencies for
China to suffer a decline in its competitive position.


The major argument for China to revalue its currency is that it has enjoyed
a higher productivity growth rate than the US and many other countries. This
has caused the real exchange rate to depreciate despite the fact that it was
long pegged to the US dollar in nominal terms. China itself recognized the
case for revaluation in 2005. It began to float the renminbi and allowed it
to appreciate by 20% against the US dollar. It re-pegged the currency in
July 2008 because of concern about the global financial crisis. During the
next nine months, its export-oriented firms in the south lost twenty million
jobs and sent many migrant workers home. China was naturally concerned about
its social stability. China pursued a highly expansionary fiscal and
monetary policy during late 2008 and 2009 in order to eliminate the risk of
recession in its economy. It announced a $600 billion infrastructure
spending program and allowed bank lending to increase by 30%, which is the
highest growth rate since the period of high inflation during the early
1990s. China’s policy was more expansionary than any other country in the
G-20, and it played a significant role in stabilizing the global economy
last year. There has been a large increase in China’s imports which has
reduced the trade surplus from 6.9% of GDP during 2009 to 2.9% in 2010. The
Chinese policies also produced a major rebound in commodity prices, and gave
a significant boost to growth in emerging market countries in Africa and
Latin America, as well as Australia and Canada.


China’s economy has made a complete recovery from the downturn and is now
suffering from overheating. There are once again labor shortages in the
south. This factor is producing a wave of strikes and driving up wages by
30-40%. China has also been experiencing property bubbles in major cities
such as Beijing and Shanghai.


There is little doubt that China will need a more restrictive monetary
policy this year. The central bank has already raised reserve requirements
three times. The authorities have told large state-owned companies to reduce
commercial real estate investment and the banks to increase the down
payments for residential property transactions. China is more willing to use
direct controls on property lending than the US in order to ensure that
asset markets do not overheat. The next step will be to raise interest rates
in order to prevent real yields on household deposits from turning negative.


China has also announced that it will now revert to a more flexible exchange
rate policy which should encourage the renminbi to appreciate by 3-5% during
the next six months. Inflation is not the only reason for currency
appreciation. Other G-20 countries, such as Brazil and India, have begun to
lobby China for a currency revaluation because their domestic tradable goods
industries regard the renminbi peg to the dollar as a mercantilist trade
policy. They are suffering from competition with China while their own
currencies are far more flexible. The Brazilian real appreciated by 30%
against the US dollar last year. As China has been trying to form an
alliance with the other BRIC countries to shape global economic policy, it
cannot ignore their complaints about its own exchange rate policy.


China has been reluctant to revalue this year because its policy makers have
memories of how the global economy surprised them in 2008. They fear that
there could be a double dip in the US while they are shocked by recent
developments in Europe. The financial crisis of southern Europe is a concern
because Europe is now China’s largest export market—Europe takes 22% of
China’s exports. The crisis has caused the euro to slide by 10% against the
renminbi during the past three months. China’s exports are enjoying a strong
rebound despite Europe’s problems, so policy makers in Beijing are now
accepting the case for a revaluation, but they will remain cautious until
there is more of a consensus about the resilience of the US economy. They do
not want to be surprised again by a sudden downturn of the US and global
economies.


The Obama administration recognizes the constraints that are confronting
Chinese economic policy, and it did not use its recent economic summit in
Beijing to focus only on the exchange rate question. The Congress must also
learn how to manage its relations with China. Congress should recognize the
significant contributions which China made to the global recovery last year.
China will revalue its currency gradually during the next twelve months and
significantly over the next five years. It will do so because it needs to
shift its economic leadership more towards domestic consumption while there
are decreasing benefits from accumulating massive foreign exchange reserves
as China finances the US fiscal deficit. Congress can only distract from
this process by making threats against China. The Chinese do not want to
appear to be succumbing to US pressure. They want the world to think that
they are setting exchange rate policy to achieve China’s own economic
objectives while maintaining harmonious relations with other developing
countries.


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