THE future of China’s currency, the yuan — known locally as the renminbi — and of its peg to the US dollar is one of a handful of crucial issues facing the world economy.
Over the past few days speculation has intensified that the Chinese authorities are poised imminently to announce a move to revalue the yuan. Could this, then, finally, be the long-awaited moment? In considering this question, it is important to bear in mind the utter determination of Beijing not to be rushed into action over the yuan, and to proceed at its own pace.
There are, though, some signs that something just might be about to happen. One clue was that China chose not to attend recent London talks of finance ministers from the Group of Seven leading economies. The last thing that Beijing would want if it were about to move would be any appearance of responding to G7 pressure. Meanwhile, it emerged last week that Bush Administration officials have told key US senators that China may act next month, before a visit to Washington in September by President Hu Jintao.
The economic case for a yuan revaluation is growing steadily as each month’s trade data bring more and more evidence of the Chinese currency’s entrenched competitiveness, sustained by a dollar peg that appears to keep it undervalued.
Last week, China reported a June trade surplus of $9.7 billion (£5.5 billion), its highest monthly figure this year, as its exports leapt at an annual rate of more than 30 per cent. As Jim O’Neill, of Goldman Sachs, observes, the surplus for the first half of this year, at $39 billion, is larger already than the $32.8 billion that it notched up for the whole of last year. He expects a full-year surplus for this year of more than $69 billion, or close to 4 per cent of China’s GDP.
This strong indication of currency undervaluation is reinforced by the broader picture of the Chinese current account, which Mr O’Neill forecasts is headed for at least $120 billion this year.
Still, if China’s trading performance strongly suggests that the yuan’s dollar peg is keeping the currency undervalued, and allowing Beijing a significant global competitive advantage, it is important to note that America’s repeated case for a yuan revaluation based on its own trade deficit with China is a lot weaker.
Even if the yuan were to appreciate very sharply, it is doubtful that, given China’s enormous advantages over the United States in terms of labour and other costs, and the strength of American consumer demand, there would be a big shift in the trade gap between the two countries.
In any case, if Beijing does move soon to alter the yuan peg, its reasons will have relatively little to do with these international perspectives and a whole lot more to do with China’s domestic political and economic imperatives.
The Chinese economy has been expanding at an unsustainably breakneck pace for a prolonged period, raising anxieties of overheating, the creation of an investment bubble and inflation. Recently, amid fears that this could end in an economic "hard landing", sending the economy crashing to earth, Beijing has acted to try to restrain growth. It has tightened lending conditions imposed by commercial banks to restrict the supply of capital and ordered interest-rate increases, albeit very modest ones.
The policy squeeze has worked to an extent, with loan growth decelerating along with demand for imports, and other signs that the past, sizzling pace of economic expansion has eased a little.
Yet the currency peg makes effective operation of monetary policy in China very problematic. The combination of higher interest rates and an exchange rate perceived to be undervalued is the perfect lure for hot money inflows. So, even as China tries to tighten policy to curb inflation, it acts as a magnet for international capital, and these inflows in turn boost domestic liquidity, stoking inflationary pressures.
To tackle this problem, Beijing is forced to "sterilise" the inflows by selling large volumes of domestic commercial paper and bonds, which mop up the "hot money". But, as Paul Mortimer-Lee, of BNP Paribas, points out, the sheer scale of the capital inflows makes this process increasingly difficult and creates dangerous imbalances, weakening the balance sheets of China’s already shaky domestic banks.
It is, then, mainly for a range of domestic reasons such as these that China seems increasingly likely to move soon to loosen the yuan peg in some way — even if the need to assuage international protectionist pressures, especially in the US, will also play a part.
Domestic factors also suggest that Beijing will move slowly and cautiously. For one thing, China has yet to put in place the financial infrastructure and expertise that would permit a drastic move to a floating currency. For another, Beijing needs to maintain rapid growth to create the millions of new jobs necessary to avoid an eruption of political and social tensions.
This is just as well. Whatever Washington’s public assertions, the drastic options for the yuan — some form of float (whether managed or not) or a very large upward revaluation with a new peg at a higher rate — carry very large risks, not just for China but for the global economy.
The huge resulting flows of international capital out of China would be immensely disruptive and destabilising for an ill-prepared Chinese banking system. Chinese growth could take a severe knock. For the US, meanwhile, the ensuing evaporation of Chinese demand for Treasury bonds would risk triggering a sharp rise in American market interest rates, in a damaging blow to growth there. The dollar and US shares could fall sharply.
All of this points to Beijing opting for one of three more modest options for the yuan: a small move in the existing peg or a widening of the bands within which the currency can fluctuate against the existing peg; a move to a so-called "crawling peg", in which the level of the peg is moved steadily upward over time; or a switch to a peg against a wider basket of currencies.
These possibilities themselves carry substantial risks, however. As Mr Mortimer-Lee argues, a move to a basket of currencies, depending on its structure, could still trigger a slide in the dollar and US Treasuries. And a crawling peg or other modest change to the existing regime would essentially mark an effort by Beijing to buy time. The danger here would be that markets’ anticipation of bigger moves in future would generate more disruptive speculative pressures than doing nothing.
For the decision-makers in Beijing, then, making the right move is a Chinese puzzle of great complexity. Whatever solution they choose will have profound global repercussions.
