Renminbi: Up, Where It Belongs

Jehangir S. Pocha is NPQ’s contributing editor for Asia, based in Beijing.

Beijing — China’s decision to revalue its currency upward by 2.1 percent and scrap its peg to the United States dollar in favor of a basket of currencies has sent rumbles through the global financial system.

This is the first change in the value of the renminbi (RMB), or yuan, since 1997, when its rate was set at 8.28 to the dollar. The recent changes will raise the value of the RMB to 8.11 to the dollar and the People’s Bank of China, China’s central bank, has said it will also allow the RMB to trade within a band of 0.3 percent for the first time.

Beijing has been painting its decision as an accommodation of US concerns. Almost a year ago, numerous US legislators had begun accusing China of deliberately keeping its currency undervalued to promote exports. They argued that this had caused the loss of 2.8 million American jobs and fueled a trade deficit of about $162 billion last year alone. With manufacturing outsourcing sending good American jobs to China and a low RMB sending cheap Chinese products to America, the line that China was robbing the US blind carried an easy credibility with voters in textile and manufacturing states, such as North Carolina. In April, 67 out of 100 US senators gave their initial backing to a measure sponsored by Sens. Charles Schumer (D-NY) and Lindsey Graham (R-SC) that would have imposed a 27.5 percent tariff on all Chinese imports unless Beijing revalued the RMB within six months. The harshest of these critics had demanded that Beijing revalue the RMB by as much as 40 percent, or allow it to float freely, with the market determining its value.

China has acquiesced to this pressure, but only after getting the US to tamp down on its public posturing and stressing that any decision on the RMB would be taken after consulting the G-8, the International Monetary Fund, the World Bank and other Asian economies, a move clearly designed to make China look like a responsive and mature global player. Yet, the degree of Beijing’s revaluation has been so timid that several economists say it will have little material impact on China’s continuing export boom, which continues to grow at about 12 percent a year, according to government reports.

“(Two percent) is too small to make a difference to trade or capital flows,” says Arthur Kroeber, managing editor of the China Economic Quarterly, a research and analysis firm in Beijing.

This is particularly so because, though China presents itself as the world’s factory, it is actually the world’s assembler, mainly relying on its cheap labor to assemble imported components into finished products for export. Since China’s local value-added to exports has been calculated to be between 10 and 30 percent, even a 25 percent revaluation would raise prices of many Chinese exports by only about 2.5 to 8 percent.

John Rutledge, a leading economist and former US presidential adviser, says the changes will also do little to establish a “value” for the RMB.

“The essence of the policy they have left behind is a fixed rate—which they’ve done because it is a great comfort to (foreign) investors as this protects them from inflation and currency fluctuations,” he says. “All they’ve done is replace the dollar peg with a basket that shifts the peg more toward China’s real trading patterns.”

With Chinese products often being between 20 and 200 percent cheaper than their competitors’, a 2 percent change in exchange rate is not expected to alter demand in most industries. While price-sensitive, low-margin industries such as textiles and electronics-assembling could be affected due to the growing competitiveness of exports from other emerging markets, such as Vietnam, no major economic think tank or analyst has predicted an appreciable slowdown in Chinese exports.

Yet US Treasury Secretary John Snow called Beijing’s move “extremely positive” and said it showed that Beijing was “on the right path.” Numerous trade and finance ministers, including from Germany, Australia, Japan and Thailand, also said they expected to see their countries’ exports to China rise.

Kroeber says the timing to the revaluation indicates that Beijing and Washington are particularly interested in settling the political turmoil incessant demands for a revaluation of the RMB have created.

“(The announcement) came just ahead of President Hu Jintao’s visit to the US, and it enabled him to argue that China has now done its part in mitigating the huge US trade deficit with China,” Kroeber says. “Yet it was also done early enough so that Beijing can claim to its domestic audience that it was making the move on its own terms, not simply in response to pressure from Uncle Sam. Politically, the move also enables the Bush administration to declare victory in its two-year campaign of quiet persuasion on the currency issue (and) take the wind out of the sails of the China-as-currency-manipulator argument.”

One reason the Bush administration would like to contain the revaluation issue is that it challenges the informal but effective system of global finance management that has emerged between the US and Asian economies over the last 20 years.

“This small move is a beginning of a much larger currency regime change in China and Asia,” Nouriel Roubini, an associate professor of economics at New York University’s Stern School of Business and previously a senior economist at the White House Council of Economic Advisers, has written. “It may be the beginning of the unraveling of the so-called Bretton Woods II regime, a regime that has allowed until now the cheap financing of the US’ twin deficits (budget and trade).”

The Bretton Woods II hypothesis, put forward by the leading economists David Folkerts-Landau, Peter Garber and Michael Dooley, adheres to the idea that de facto the world is once again following a regime of global fixed exchange rates just like the original Bretton Woods regime maintained de jure from 1945 to 1973. While the original Bretton Woods was a formal system that fixed nations’ currency rates to their gold reserves, Bretton Woods II is an informal arrangement that pegs exchange rates to the US dollar.

Today, more than 30 nations, including Saudi Arabia, Taiwan and Hong Kong, have their exchange rates pegged to the US dollar. Essentially, the system allows these nations to maintain current account surpluses, as long as their surplus is recycled back into funding the US current account deficit, which was $415 billion last year alone. Holding the agreement in place is an understanding that the US Federal Reserve will produce enough money supply to stimulate spending with US consumers, who will then buy Asian-made clothes and home theater systems (or Saudi oil) via the “fixed” exchange rate. The Asian countries will then invest their earning into US T-bills—in other words, lending it back to the US so the cycle can repeat itself over and over again.

China currently holds about $250 billion of the US’ total national debt of $7.8 trillion, $4 trillion of which is in tradable bonds. That’s second only to Japan, which holds $685 billion. If the imperatives for China to buy US debt fade, the US government may have to push up the interest rate it offers on T-bills to make them more attractive to investors. Speculators have already driven US government bonds to drop after China’s announcement, with the yield on the 10-year note rising 0.11 percentage points, to 4.27 percent. That’s up from 4 percent in May, when Chinese and Japanese investors bought some $60 billion of US securities. If a 2 percent change in the RMB has this effect, a more radical revaluation could throw the US government’s system of funding into turmoil. Already Malaysia announced just hours after China that it, too, was ending its 7-year-old peg to the US dollar and moving toward a managed float. And a proposal has already been made by Thailand that Asian economies should stop buying US T-bills and switch to investing the money in each others’ debt instruments. That way, Asian money would switch from subsidizing US debt and consumers to fueling regional development and codependence.

So upward revaluations in Asian economies—which seemed like a grand solution to the US trade deficit—will translate directly into higher mortgage rates for American home owners, and it accelerates the end of the great American real estate boom by pushing home prices lower, Rutledge says. “Essentially, the yuan revaluation amounts to a massive transfer of wealth, measured in home values and stock market values, from home owners to a small number of ( US) textile and other companies.”

So far, Beijing has been uncharacteristically open in its currency deliberations. In May last year, China invited top US economists to debate its currency policy at a two-day conference in the seaside town of Dalian. ( Stanford University’s Ronald McKinnon and Columbia University’s Nobel Prize-winning Robert Mundell didn’t support a change to China’s peg to the dollar, while Harvard University’s Jeffrey Frankel and Morris Goldstein of the Institute for International Economics in Washington did.) Beijing was also careful in preparing the market for months with well-placed leaks about its intentions and even informed John Snow and several prominent bankers of its plans in advance of its public announcement. Yet markets reacted strongly to news of the revaluation. Both Japan’s Nikkei index and the South Korea’s Kospi index fell 1 percent, led by falls in export-oriented stocks such as Toyota Motor Co. and Hyundai Motor Co. Conversely, Asian currencies, including the Taiwan and Singapore dollar, South Korean won and Japanese yen rose 1 percent due to pressure from speculators.

Rutledge says speculators are the wild cards that could sink China’s revaluation strategy.

“Managed floats are a disaster because they attract speculators like blood attracts sharks,” Rutledge says. “Once a government shows it is willing to accommodate political pressures on its currency, the speculators will attack it. So the big celebration (when Beijing announced its changes) was in George Soros’ office.”

Still, changing geopolitical equations also make it prudent for both the US and China to temper, if not reconsider, the Bretton Woods II system. In the US, many feel the national debt has reached astonishing proportions, and there is growing concern about making the country too dependent on a China that is increasingly challenging the US on economic and security matters. Chinese General Zhu Chendu’s recent comments that China nuke the US if attacked China during a confrontation over Taiwan only amplified those concerns for average Americans.

For China, the concerns are more immediate. China’s huge surplus, as well as its domestic savings rate of more than 40 percent of GDP, one of the highest in the world, has swelled its domestic money supply. Normally this would have resulted in the RMB appreciating, but since the Chinese central bank kept the RMB undervalued, the increased liquidity is threatening to raise domestic prices. In stability-conscious China, where leaders maintain their fraying legitimacy through sound economic performance, that could prove dangerous, and local journalists say they have been banned for writing about the revaluation. Political protests have seen a steady rise over the past few years, and in 2003 the country experienced more than 50,000 demonstrations over issues as diverse as unpaid pensions, land seizures by the government and local corruption, according to reports from the Ministry of Public Security.

Recently, China’s central bank said it was aiming to cap inflation, which rose to 5.3 percent last year, at between 3 and 4 percent this year. Kroeber, the Beijing-based analyst, says letting the yuan strengthen may help President Hu Jintao control inflation by reducing the cost of imported products such as oil and capital goods. It would also allow China’s central bank the option of increasing interest rates to cool the economy that expanded 9.5 percent in the first quarter of this year, despite efforts to slow it down.

“In the short run, Beijing walks away with what it wants,” Rutledge says. “But what we need to understand is what the unintended consequences of this will be. There is not enough data to predict this. The single most important question for China is whether growth can continue and for that it needs continuous investment. A fixed RMB gave investors the comfort of investing without exchange or inflation risk. Basically it outsourced China’s inflation control to Alan Greenspan. With managed float control that has gone back to Beijing. I think the US pressure on China to do this was a mistake, because financial maneuvering could end up being quite tricky for China.”

The unpredictability of the outcome of Beijing’s decision was underlined when the RMB actually fell slightly against the dollar on its first day of trading in China’s central foreign exchange market, which is dominated by China’s central bank. In fact, many economists maintain that China’s modest RMB appreciation is a baby step designed to give its central bank some experience in how to manage a flexible currency. That’s not a small thing, for people tend to forget that China didn’t have a formal banking system or currency until the early part of the 20th century. Its Communist-era currency was so poorly managed that it had to be devalued 33 percent in 1994 and its banking system is still a mess.

For now, observers are optimistic about the financial management capabilities of Zhou Xiaochuan, the measured head of China’s central bank, as well as the young leaders that have risen to prominence after President Hu Jintao took over from previous President Jiang Zemin two years ago. Zhou has encouraged expectations of further appreciation in the RMB by calling the 2.1 percent rise an “adjustment.” But both President Hun Jintao and Premier Wen Jiabao are said to fear that a strong RMB could create instability in both urban and rural areas, as a fall in exports would hurt job creation, and cheaper food imports could hit local farmers.

Kroeber says it could be years, even decades, before the RMB is allowed to fully float.

“It was never the goal of Chinese policy to ‘correct’ external imbalances by a revaluation,” Kroeber says. “The long-term goal is a crawling peg delivering some appreciation against the dollar, but this goal will be realized over 20 years or so. Those expecting further upward revaluations in the RMB in the near term will be disappointed.”

But if it all works out and Beijing engineers the “soft landing” for its bloated monetary system that investors are hoping for, it will have taken a critical step toward shoring up its rickety and corrupt financial system and turning itself into a global economic superpower.