Jan 10th 2008
China is allowing its currency to rise more rapidly. Why?
IN 2005 two American senators introduced a bill into Congress that threatened to slap a tariff of 27.5% on all Chinese imports unless the yuan was revalued by the same amount (their estimate of how much the currency was undervalued). That legislation was dropped, but several other China-bashing bills are still working their way through Congress and accusations about "unfair" Chinese competition will surely play a big role in this year's presidential election. Many American politicians and economists talk as if the yuan was still fixed against the dollar. Yet on current trends, by the time the next president enters the White House the yuan could be within spitting distance of the magic figure demanded in 2005.
Since the beginning of October the yuan has climbed at an annual rate of 13% against the dollar--its fastest pace since China stopped pegging to the dollar in July 2005 (see chart). Since 2005 it has appreciated by a total of 14%. The offshore forward market is pricing in another 8% increase over the next 12 months; several economists are betting on a rise of 10% or more.
It may appear as if Beijing has caved in to Washington's demands. But the main reason why China is allowing the yuan to rise faster is because its policymakers believe the benefits to China from a rising currency now outweigh the costs. Beijing's top concern today is inflation, which rose to 6.9% in November. On January 9th the government announced tighter price controls on a range of products. The People's Bank of China (PBOC) increased interest rates six times in 2007, but this is unlikely to squeeze inflation, which has been driven largely by a jump in food prices caused by supply-side shocks. A faster pace of currency appreciation offers a more powerful weapon: it will help to reduce imported inflation, especially of food and raw
materials. By reducing the need to intervene to hold down the currency, it will also curb the build-up of foreign-exchange reserves and hence monetary growth.
Another reason for the shift in policy is that the costs of holding down the yuan are rising. The PBOC has so far succeeded in "sterilising" most foreign-exchange inflows--printing yuan to buy incoming dollars and then selling bonds to banks in order to mop up the resulting excess liquidity. It has even made a profit on this activity, because the return on its dollar reserves exceeded the rate it paid out on sterilisation bonds. Now, however, the PBOC is losing money. Thanks to falling interest rates in America and rising rates in China, Chinese rates are now higher than those in America and the gap is likely to widen this year. Since the shrinking yuan value of China's dollar reserves also has to be reported as a loss, the cost of currency
intervention is higher still.
Higher yields in China than in America are also likely to mean bigger inflows of foreign capital. The PBOC would then have to buy even more foreign exchange to hold down the yuan, increasing the required amount of sterilisation. On January 3rd the one-year dollar LIBOR rate (the cost of funding a carry trade using dollars) fell below the Chinese one-year deposit rate for the first time since China abandoned the dollar peg. Add in the expected appreciation over the next year, and investing in yuan is highly attractive.
China's capital controls give it some protection from speculative inflows, but they are leaky. Businesses can build up positions in yuan by over-invoicing exports and under-invoicing imports. Some economists argue that a big one-off revaluation would help to stem inflows by reducing the expected future appreciation of the yuan. But Chinese policymakers have stressed the need for gradual adjustment. To show that the currency is not just a one-way bet, the PBOC may try to nudge the yuan a bit lower in coming days.
The yuan's rise is unlikely to silence flag-waving American Congressmen or economists. The slide in the dollar since 2005 means the yuan has risen by only 5% in trade-weighted terms, according to the Bank for International Settlements. China's current-account surplus has risen from 4% of GDP in 2004 to 11% last year, so any gauge that defines the equilibrium exchange rate as the rate that would eliminate the surplus would suggest the yuan is now even more undervalued. In 2005 Morris Goldstein and Nicholas Lardy at the Peterson Institute for International Economics estimated the yuan was 20-25% undervalued. By late 2007 they thought it was at least 30-40% undervalued despite its gain over the previous two years.
But other economists say it is wrong to define the yuan's correct value by the size of the current-account surplus. In particular, it is unclear how a revaluation would correct China's savings-investment imbalance, which underlies that surplus. A recent report from the Conference Board, an American business-research organisation, argued that: "Although an undervalued currency contributes to China's trade surplus, it is not a primary cause of it and has very little to do with the bilateral United States-China trade deficit."
Most Congressmen believe otherwise. The problem with China's appreciation by stealth is that it gets no credit from its critics for doing so. If China had delivered the past two years' currency appreciation in one go it might now be getting less flak from its detractors in America.