The currency debate re-ignites?

The holiday week continues to limit information and policy-making, and of course the Chinese stock markets are closed, but there were nonetheless two interesting articles, one in the Chinese press and one from abroad, worth noting.  The first was a very long article in today’s Xinhua called “The rise of the yuan – where now for China’s currency?” in which the author, Zhu Yifan interviewed a number of economists on prospects for the RMB.

After going through the benefits a rising RMB has had for Chinese consumers and the costs to exporters, the article shifts gears and refers to the currency regime as a structural part of China’s problem:

The reverberations of the rapid appreciation of the yuan are deep and complicated. The change was not as simple as a boost in buying power or a squeezed trade surplus. Behind it lies a shift in the country’s overall economic strategy, driven by recognition that the current export structure won’t support economic development the way it used to.

“China’s currency had been kept in an undervalued state since the 1997 Asian Financial Crisis, and the government in effect used it to finance the imports and exports sector at the cost of its non-trading industries,” says Professor Pan Yingli, of the Shanghai Jiao Tong University management school.  A large profit margin was then created between low production costs paid in undervalued yuan, and the high revenues reaped by selling these products to international clients.

This brought prosperity for the country, but took a heavy toll with high pollution and energy consumption. Too much labor-intensive industry with low-efficiency and little added value stretched supply by demanding evermore manufacturing materials, which pushed up upstream prices. The heavy reliance on overseas markets was detrimental to the establishment of an overall balanced industrial structure in China.  It also created a persistent gap between the well-developed coastal east, which thrived by trading with the outside, and the poor central and western regions in China.

“The structural conflict has accumulated to a stage that demands a solution,” says Pan.  “Strengthening the yuan is the rational choice as it helps stabilize inflation and leads to the optimization of industrial structure.”

The article then goes on to point out that the strategy to accelerate the RMB’s appreciation foundered, as should only have been expected, on the issue of speculative hot money inflows, which have poured into the country in the last year.  It quotes Liu Yuhui, researcher with Chinese Academy of Social Sciences, as warning that losing control of capital inflows would ultimately cause policy-makers to lose control of the underlying macro-economy – something which, I believe, has already happened.

I am not sure where the article was ultimately headed – it concludes:

Given the complexity of the situation, opinion is divided over whether the appreciation will continue, or whether there will be a one-off appreciation to end the uncertainty. Guesses are made at the so-called ceiling of the yuan. Central bank governor Zhou Xiaochuan says China would gradually expand the elasticity of the exchange rate, sending out the signal that Beijing would let the yuan fluctuate rather than rise unilaterally.

The fast appreciation of the yuan in the first half might not continue, and the concern over possible fallback of foreign trade could weigh against continuous further appreciation, says Peng Xingyun, of the Chinese Academy of Social Sciences.  “There are many factors in the market that affect supply and demand, which, if changed, would sway the exchange rates,” says Peng.

Still, I think this article was the strongest example of a recent spate of articles I have noticed reopening the debate over the RMB.  In the past month or so we have seen a sharp decline in the rate of appreciation of the currency, and I think there is a big debate with policymakers on one hand arguing that with a slowing world economy and declining export growth this is the wrong time to be raising the value of the RMB, and on the other hand recognizing that China needs desperately to rebalance its economy away from export orientation and, just as desperately, needs to regain control of its own monetary policy.

The only thing I can add to the debate is the fear that policymakers waited way too long to resolve this debate, and I think in particular the last year of massive inflows has probably undermined the financial system to the point where it is very vulnerable to shocks.  In a sense, they’re damned if they do and damned if they don’t.  Maintaining the value of the currency continues the unbalance, speeding up the appreciation re-ignites speculative inflows, and even my once-favored response – a one-off revaluation – is now a very risky strategy that could provide the shock needed to cause the banking system to unravel.

Add to the mix the second article I found interesting today.  John Thornhill has a piece in today’s Financial Times about the developing political and economic strains between China and Europe.  I have argued for a long time that as long as China maintained its currency regime it forced a trade deficit onto the rest of the world, which for the most part meant the US.  However as the dollar weakened versus the euro in response to the strains associated with the US trade deficit, it shifted China’s trade surplus from the US to Europe, something which I never believed could last very long.  Europe simply doesn’t have the labor and financial flexibility and has too many “old” industries for it to be able to accept a sustained trade deficit with China.

China’s astonishing economic rise over the past three decades has unsettled many countries and regions, but perhaps nowhere more than Europe, which in some respects still regards itself as the centre of the world.  For a while, Europe’s politicians and business leaders marvelled at China’s economic dynamism and applauded its successes in reducing mass poverty. Alarmed at US unilateralism at the time of the Iraq war, leaders such as Jacques Chirac of France and Gerhard Schröder of Germany even held out the prospect of a fully-fledged strategic partnership with the growing power. The European Union has been steadily developing an extensive – and largely positive – dialogue with China over a vast range of subjects spanning economics and trade, the role of the United Nations, counter-terrorism, cultural exchanges, Iran, North Korea, Darfur and Burma.

However, as the world’s centre of economic gravity slips inexorably eastwards, the perception appears to be spreading among European voters that China’s rise is as much of a curse as a blessing. As China has regained its reputation as the workshop of the world, it has seemingly sucked manufacturing plants and jobs out of Europe and flooded the EU with cheap manufactured imports. The EU’s trade deficit with China has recently been rising by an estimated €15m an hour.

The article quotes Eberhard Sandschneider, director of the German Council on Foreign Relations, as saying “Europe has switched from China hype to China angst.”  He adds: “The popular view is that the Chinese are stealing our jobs.”

Anti-China feeling has been rising sharply in Europe and I think this seriously limits China’s room for maneuvering, especially on the RMB.  I just saw an interview with Steve Roach, the chairman of Morgan Stanley Asia, and he is convinced that the dollar is due for more weakness against the euro.  I am not sure I agree, but any dollar weakness is going to cause real problems between China and Europe since dollar weakness also means RMB weakness.

China is going to be forced somehow to adjust just its monetary policies just when everything on the external front has gone wrong.  This won’t be easy.  We should all hope the recession associated with the US financial crisis is very, very mild.

Originally published at China Financial Markets on Oct 1, 2008 and reproduced here with the author’s permission.