China’s yuan peg revisited


By Baljeet Grewal

Mounting US trade deficits and surging Chinese exports have fuelled speculation in global currency markets of a yuan revaluation. 

China has, however, remained steadfast in its resolve to weather the barrage of criticism of the peg, preferring to revalue at its own pace. But revaluation is not as explicitly beneficial to the United States – nor unmistakably detrimental to China – as political rhetoric might suggest. 

Fundamentally lost in the cacophony of debate over the currency peg is any consideration of the negative effect on the process of financial liberalisation in China. The yuan was pegged to the greenback – at 8.30 to the dollar in 1995. As with all pegs, this was to ensure that currency volatility would not interfere with trade and investment flows on which the country’s growth vitally depends, and to build confidence in the currency and the government’s management of it. 

When a government pegs its currency, it essentially commits to a non-inflationary monetary and fiscal policy – something the Chinese have consistently delivered. 

When the Asian financial crisis battered currencies of the region in the late 90s, the yuan strengthened as much as 40% against its neighbours – and China received streams of commendations by the international financial community, more so for resisting the temptation to devalue and surviving painful domestic deflation to maintain export competitiveness. But as the US dollar weakened against major currencies late last year, the yuan saw its value concurrently diminish, prompting calls for China to unshackle its peg due to “artificially cheap exports” and purported currency manipulation. 

A revaluation of the yuan should be made at a pace that allows China to reform its debt-laden financial sector without negating exports and domestic growth. - Reuterspic

As any sound-minded wilful economist will contest: this is simply the nature of currency pegs. China is neither manipulating its currency nor making its goods artificially cheap; it is plainly maintaining the value of its currency against the dollar – as it has done for the past nine years. Essentially, it is the weakness of the dollar that has caused the yuan to weaken. 

China’s peg may be many things, but it is certainly not causing the US trade deficit. Chinese imports are too small to have much impact on the United States. China accounts for 13.4% of total US imports, and the proportion of this to the US gross domestic product (GDP) is less that 3%. 

Essentially, job losses in this respect do not hinge on China. US unemployment has other more pressing macro causes, for instance, the ballooning twin deficits have hampered growth in the manufacturing sector, high commodity prices have limited capacity expansion, and private investments are all but a pitiful trickle. 

There is no question that China’s exports are cheap and competitive, but this has less to do with the yuan than it has with China’s labour cost. China’s wages are 4% of those in the United States – no conceivable revaluation will make America any more competitive. 

A revaluation would render China’s export-oriented businesses less competitive on world markets, and their distress would worsen the already significant non-performing loan and under-capitalisation problems at China’s state-owned banks. 

On the flip side, massive capital inflows have caused economic distortions in China and if remained untreated, could potentially jeopardise the real economy – but this should be done at a pace that allows China to reform its bourgeoning debt-laden financial sector without negating exports and domestic growth. 

If China decides to repeg, it will have to convince global markets that the new value is at equilibrium – to discourage further speculation and destabilisation. 

China’s currency regime could also potentially boomerang on the United States. Under its fixed-rate regime, China’s central bank constantly buys billions of dollars on the currency markets, which are invested in US Treasury bonds and provide a major source of financing for the federal budget deficit. As at January 2005, China held US$194.5bil worth of Treasuries, second only to Japan’s US$702bil. 

If the flow of money from China into the dollar and Treasury bonds dries up, financial turbulence might well ensue: the dollar would fall even further (along with the yuan), inflation and interest rates would rise and the cost on American jobs will be far greater. 

While a revaluation is potentially imminent, the timing and considerations under which it is done should centre on China’s domestic economic policies and not because of China’s trade surpluses. Those “surplus'' earnings are currently funding the US economy – to quote a famous Chinese proverb, “The first rule of good manners, and finance, is that you should not bite the hand that feeds you.'' 

 

·The writer is chief economist and head, fixed income research at Aseambankers Malaysia Bhd, the investment banking arm of Malayan Banking Bhd

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