MANAGING THE FLOAT
How quickly should the yuan rise?
By Don Durfee

Over the years, China’s currency has sparked a host of arguments. Is the yuan massively undervalued or not? Is China a currency manipulator or just a victim of its own exporting success? Have government efforts to keep the yuan cheap produced an economy woozy from too much cash, or is all that money being put to good use?

These debates inevitably lead to the most urgent question of all: how quickly should China allow the yuan to appreciate? China’s policy makers have allowed their currency to gain some value – since 2004, the yuan has risen 9.5% against the dollar. In real trade-weighted terms, however, that increase has been a mere 5.4%. The Chinese government has resisted demands to act faster.

Some economists – and, of course, many Western politicians – push for an immediate, “full” revaluation. They suggest that China faces dire risks by tolerating its surging trade surplus, which grew by US$24.4 bn in July and now stands at US$136.8 bn for the first seven months of this year.

Others contend that the currency issue isn’t nearly so urgent – the yuan should appreciate faster than today’s annual rate of about 4% against the dollar, but not all at once. A quick revaluation could put exporters out of business and trigger big flows of money out of China. “The trade surplus is clearly a problem, but it’s not an emergency,” says Stephen Green, senior economist with Standard Chartered. “So why take such a big risk as moving the currency 10% or 20% in just a couple of weeks?”

A surprise surplus

Estimates of just how undervalued the yuan is range widely, from 10% to 40%. No one doubts, however, that the yuan’s value has become an increasingly grave point of friction between China and its trade partners.

The political uproar is ironic, says Jonathan Anderson, chief Asia economist for UBS. When China initiated its peg to the US dollar in 1997, it wasn’t to keep the currency from rising, but rather to keep it from plummeting. The Asian economic crisis was underway, and many Western economists were urging China’s central bankers to prevent a collapse of the yuan. (They succeeded: China managed to maintain its peg throughout the crisis.)

China ran only modest trade surpluses – even falling into deficit in mid-2004 – until the end of 2004, and there was no indication that its currency was undervalued. When the surplus soared starting in early 2005, China’s leaders were as surprised as anyone, says Anderson. The cause wasn’t the value of the yuan, but overinvestment in heavy industry. China exports mostly low-end manufacturing goods such as toys and clothes. Typically, such exporters need to import expensive capital and industrial goods to keep their factories humming, and this helps keep trade in balance.

But something else happened. In the early part of this decade, China’s property, construction, and automotive businesses were booming. Sensing a chance to make money, state-owned enterprises and local governments got into the business of supplying the machines and industrial materials needed to sustain the boom, leading to heavy investments in things like smelting and machinery production. Banks helped out with vast quantities of cheap loans.

The central authorities decided that the property and construction business had entered bubble territory and sharply cut real estate lending just as all of those steel mills and factories began churning out their goods. The government didn’t halt heavy industrial investment, though, and when these new producers found they had few domestic customers, they instead began selling overseas. China is still exporting these goods that it would otherwise have imported, helping to explain the surging surplus and the resulting foreign exchange inflows.

In other words, concludes Anderson, many of China’s critics confuse cause and effect. “Currency didn’t get China into this mess,” he says. “But now they’re in this situation where if you let the renminbi go tomorrow, it would skyrocket.”

Vicious cycle?

Regardless of how it happened, the government now faces pressure to act, for both economic and political reasons. Michael Pettis, a professor of finance at Beijing University is one of those who argues for quick action, preferably in the form of a big, one-off revaluation. He sees a harmful reinforcing cycle, where big forex inflows stimulate overinvestment, feeding China’s ever-growing surplus and in turn drawing even more foreign exchange into the economy.

To understand this, consider how the People’s Bank of China (PBOC) manages the yuan. When foreign currency comes into China, either from the sale of exports or as investment capital, it gets converted to yuan on China’s currency market. In a free market, the value of the yuan would rise, since there is more demand for yuan than for dollars. But the PBOC steps in to buy foreign exchange, printing new domestic currency to pay for it.

To keep this flood of new money from overwhelming the domestic economy, the PBOC then “sterilizes” the inflows, usually by selling bonds to China’s banks, a step that effectively takes money out of circulation. It also takes administrative steps, such as forcing banks to hold more reserves. But the government doesn’t mop up all of the money coming into the economy: it only chooses to sterilize between 60 and 70% of the foreign exchange. As a consequence, the country’s money supply is increasing rapidly: M2, a broad measure of money supply, is growing by 15-17% annually.

The problem, according to Pettis, is the interaction of this extra money with China’s still-reforming banking sector. One way or the other, the money ends up on the balance sheets of the banks, which must lend it out to make a profit. That means fast lending growth – in the first quarter of 2007, loans by China’s commercial banks increased 13%. And that lending spurs overinvestment, driving exports, the trade surplus, and forex inflows higher. At some point, believes Pettis, this cycle will bring problems such as runaway inflation or else a crisis in the banking system once it becomes clear how many of these loans won’t be repaid (as many surely won’t).

“My fear is that there will be an adjustment,” says Pettis. If that happens in a benign atmosphere – continued high growth and liquidity around the world, low domestic inflation, and successful banking and financial market reforms – then the adjustment might not be too painful. But that’s a lot to count on. “It could be very messy,” he says.

China has tried but failed to break the cycle. It has raised interest rates (which remain very low), increased reserve requirements, and sterilized great quantities of forex inflows. The only lever remaining, contends Pettis, is a big, one-time revaluation of the yuan on the order of 10-15%, followed by a hard peg to the dollar. A stronger yuan would slow export growth, and make imports more attractive to Chinese consumers and help correct the trade imbalance. Pettis thinks that the move should surprise the markets – letting the currency revalue steadily will only encourage speculators to evade China’s capital controls, and bring “hot money” into the country at a time when it needs less, not more, liquidity.

That’s bound to be an unpopular recommendation in Beijing. Surprising currency traders also means catching exporters off guard, and very likely putting many of these employers out of business.

Time for action

Is such a drastic step even necessary? After all, some of China’s neighbors, including Singapore and Malaysia, have been living with even bigger imbalances for years. Nicholas Kwan, Standard Chartered’s regional head of research for Asia, doesn’t think so. China’s monetary imbalances are manageable, he says. For example, while money supply is indeed high in China – the M2/GDP ratio is now 160% – the country can easily put all that money to use. “China is still a half-market, half-planned economy where a lot of the economic sector is moving from planned to market,” says Kwan. “That means they are moving to a cash economy and need more money.” Putting formerly state-controlled real estate onto the market, for example, requires a commensurate increase in the money supply. Indeed, this need for rising liquidity is the reason China only sterilizes part of the foreign exchange that pours in daily, according to UBS’s Anderson.

There is no sign that this monetary growth is driving inflation. In July, China’s consumer inflation rate hit 5.6%, the highest in 10 years. But higher food prices explain the increase, and food is costly because of a cluster of unrelated forces, including the use of grain for biofuel, flooding in southern China, and a disease killing the country’s pigs. Prices for other mid- and low-end consumer goods are trending down or else up only slightly.

“Sterilization has been quite successful, and if you look at excess reserves in the banking system, liquidity levels are lower than they’ve been,” says Anderson. “It’s very hard to argue that forex inflows are leading to big problems domestically right now.”

Still, Kwan and Anderson agree that the time has come to act more quickly on the currency. For one thing, allowing the yuan more freedom to rise and fall with market demand would allow China to regain control over its monetary policy. Because China is trying to maintain the value of the yuan, it can’t let domestic interest rates rise much, for fear of attracting foreign capital. Continued use of tools like higher reserve requirements could eventually undermine the banking system, since it makes banks less profitable. And a more expensive yuan would ease the trade surplus, with both economic and political benefits.

But how quickly should the rates change? Anderson argues for a quicker pace than the 4-5% annually the government has been allowing – he proposes a steady increase over a couple of years that would amount to 10% per year. That, he says, would get the yuan to its equilibrium level faster without incurring too much damage. In fact, Anderson thinks that revaluation won’t affect the volume of exports – a prediction sure to cause consternation among US politicians who believe that a more expensive yuan will slow the boatloads of Chinese goods arriving on their shores. The reason is that China has such a big share of certain markets – around three-quarters of the US toy market and almost 40% of the apparel market – that it can easily pass along price increases to its customers.

Where it will help is on the import side, particularly with machinery and industrial goods. China is only recently a net exporter of such products and domestic consumers still have plenty of overseas suppliers to choose from. Furthermore, because industrial goods produced in China are made out of mostly domestic materials – unlike consumer products, which have a high proportion of imported content – any increase in the yuan’s value will immediately make imported machinery much more attractive.

As for hot money, it is indeed a worry, says Green from Standard Chartered. Earlier this year Green published a report showing that investors are sneaking large amounts of speculative money into the country, often through ruses such as overbilling for exports. But he doesn’t think that should prevent a faster rise in the yuan. Anderson agrees, pointing out that hot money movements are more closely linked to the booming property and stock markets, not to moves on the currency side.

Like his peers, Green also advocates a faster appreciation – in his case, a more gradual 7-8% annually. But he has greater sympathy for the plight of Chinese officials. Beyond the worry of putting exporters out of business, there is a risk that if the yuan reaches its equilibrium level quickly, that might trigger sudden outflows of currency, as speculators cash in their bets. But since inflation is under control and the US Congress isn’t close to passing a truly protectionist bill, there’s little to be gained from moving too fast.

“The consensus in Beijing is that if you move gradually – you can assess the status of inflows and outflows every month and adjust to that,” Green says. “And in this case there are very good reasons for moving gradually.”

Don Durfee is managing editor for CFO Asia.