TCS Daily


China Cashes In

By Peter Nolan - July 27, 2005 12:00 AM

An old Chinese curse declares, "May you live in interesting times". Last Thursday's announcement by the People's Bank of China that the fixed exchange rate between the dollar and the Chinese Renminbi will be abandoned could herald some truly interesting times for the global economy.

The last major shift in policy came about in 1994, when the People's Republic devalued its currency by over 30 percent and pegged the exchange rate at 8.28 to the dollar, the level that has held steady until last week. Initially, this devaluation gave China's exports a competitive edge, which contributed to the financial crisis affecting its competitors. Subsequently, China's steadfast adherence to the peg helped significantly in allowing the wounded tigers to recover. Since that time, the effects of the currency peg have had momentous impacts on the world economy.

Now, like Poland, Turkey and Singapore, China is likely to have a floating exchange rate subject to the heavy-handed guidance of its central bank, with a target based on the value of the currencies of its major trading partners, especially the US Dollar and the Japanese Yen. The Chinese authorities' intentions for the future remain unclear, with opinion among investors divided over whether the currency will appreciate further - as implied in the forward exchange rates quoted in the offshore markets - or remain steady near the current rate, as many analysts believe. As the dollar-renminbi exchange rate now faces an uncertain future, so does the shape of the global economy. The currency will be one arena in which the uneasy relationship between the world's political, military and economic hyperpower and its rapidly rising rival is visible.

The motivation for the move was widely attributed to a response by China to tensions over the large and expanding trade surplus the country runs with the US, with an excess of exports to America over imports of $54 billion in the opening five months of 2004 to increasing to $73 billion in 2005 to date. Political rhetoric in the US has been increasingly hostile to free trade in general and in particular the widely perceived hollowing out of America's industrial base. In the run-up to the 2004 presidential election, the Bush administration sheltered American steel makers behind tariffs and Senator John Edwards waxed nostalgically on the decline of the textile industry.

China now is wiling to accept the hit from last week's devaluation to its exporters, many of whom work on very slim profit margins. Indeed this is entirely consistent with their policies of credit controls and tax increases to limit potential overheating of their rapidly growing economy. However, Beijing may not be so accommodating in future of verbal intervention by US policy-makers, presenting a bleak prospect for open bilateral and world trade.

For the mirror image of the trade in goods -- financial flows -- the picture is equally foggy. The capital account remains controlled; China's banks are so poorly managed and already carry so much bad debt that liberalizing exchange controls could lead to a tidal wave of capital fleeing the country. However, the main impact may come from the government itself. China's trade surpluses have allowed it to build up foreign exchange researches worth over $700 billion, most of which is held in US Treasury bonds. China and other Asian exporters who use pegged or managed currencies -- Japan, Hong Kong, Korea and Taiwan -- now account for almost half of the Treasury debt held outside the government.

So far, China and the other Asian exporters have been largely content to lend their official reserves to Uncle Sam by buying US Treasury bonds. However this brings only low yields and the risks of foreign exchange losses if the dollar falls. If this flow of money into the T-bond market halted, the US Dollar would fall and rates would almost certainly have to rise by several hundred basis points to attract domestic capital back into T-bonds. Such as rise in US interest rates would likely crush the housing market and consumer spending, creating a very hard landing for the economy.

The temptation to abandon the US Treasury bond market may be reinforced by China's oft-stated political objective of seeking to moderate US hegemony by supporting alternative centers of global power. In global finance, the natural consequence would be an increase in the amount of official reserves held in the Euro. While China's new policy makes the Euro more likely to gain status as a reserve currency, this is far from inevitable: The Euro-zone's structural economic problems of low growth and high joblessness remain, as does the lack of a common fiscal policy and political authority in Brussels.

Peter Nolan is a London-based investment analyst and spokesman for the Freedom Institute Ireland.

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