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What happened with the yuan revaluation.

by gracchus Fri Jul 29th, 2005 at 09:56:07 AM EST

This diary was originally posted on Daily Kos yesterday, and I've reposted it here today at Jerome's request. Some of the more lecture-y bits about China and American attitudes toward it probably don't apply on this blog. I've updated the yuan to the July 29 fixing.

Yes, I know the yuan was revalued a week ago, but a lot of the discussion at the time was poorly informed so I thought I should post a quick diary explaining what happened and why the change in China was at least potentially important economically.

There's been a lot of China bashing on this blog, as there has been in U.S. political discourse generally. A lot of this has been spectacularly ill-informed, or based on conventional wisdom that's distorted or over-simplified or outdated, or what have you. China's government is certainly open to criticism, but ignorant criticism is ineffective.


First off. What happened last Thursday was that China in fact abandoned the yuan's 10-year-old peg at 8.28 to the dollar, replacing it with a tie to a basket of currencies. This had the immediate effect of revaluing the yuan by 2.1 percent to 8.11 to the dollar.

For some on Kos, this was all they knew and all they needed to know -- the revaluation was token, it won't help the trade balance and who knows when the Chinese will revalue again. However, the devil is in the details, and the devil in this case is poking the argument with its pitchfork. What actually happened is a lot more interesting, and potentially important.

Under the current system, China's State Administration of Foreign Exchange (often called by the acronym SAFE) fixes the yuan every afternoon based on the basket of currencies, the contents of which haven't been disclosed (It will take smart currency traders a couple of months to figure it out.) The yuan then trades in a range of 0.3 percent to the peg for the following 24 hours. Under the current system, China can gradually allow the yuan to gain value at a pace that allows its exporters to adjust.

This is much more flexible than the previous system, where the yuan was fixed at 8.28 to the dollar, period, and was allowed only to trade in a narrow range within that figure. In fact the new system is flexible enough that JPMorgan Chase & Co. is predicting that the yuan will appreciate 15 percent against the dollar by the end of 2006. This is probably a fairly aggressive estimate -- I'd be surprised if it were more than 8-10 percent at most. There's already been a tiny bit of further revaluation, today's (July 29) fixing of the yuan was at 8.1056 to the dollar -- not an inconsiderable daily move in the currency markets where fortunes are made and lost on that third decimal place.

But, wait! I hear you say. Didn't the Chinese government say don't expect much more in the way of revaluation any time soon? Well, yes, it did say that. But nobody in the markets believed it. The reason is that everybody assumed that China was just trying to discourage a surge of "hot" money into China seeking to gain from further revaluation. (If you own yuan or yuan-denominated assets and the value of the yuan rises you make a profit purely off of the foreign exchange gain.)

China's dead scared of hot money because the sudden outflow of hot money was one of the causes of the Asian financial crisis. China pretty much escaped that debacle, in part because its currency wasn't then tradeable, and so couldn't be attacked (Macau also escaped because there's no international market in the pataca. I had images of currency speculators going around with shopping bags to banks to build up a position, but none of them were that dedicated.) Now the yuan IS directly traded (there's also a market in what are called non-deliverable forwards), and is freely convertible on what's called the current account, so there is some vulnerability there.

There's going to be a lot of internal debate in China's government about how much revaluation to allow and at what pace. The trade ministry is already saying that a revaluation of any more than 5 percent will damage exports, etc., etc. China is no longer the cheapest place in the world to make things (wages are lower in Vietnam, Indonesia, Bangladesh and I believe Cambodia of countries that actually do export manufacturing), and there's a sense in the government that China shouldn't be competing purely on price to make the cheapest stuff any more. That's why in the textile disputes with the U.S. and EU it agreed to put export tariffs on some the lower-end textiles. Revaluation is one way of forcing manufacturers to give up the lower-value (and lower value-added products), move up the value chain, think about productivity and mechanize. No country wants to be stuck at the bottom of the value chain forever.

China's government is also keen to promote consumption so that growth isn't too export-dependent. That's why, starting a few years ago, it started giving everyone long breaks around national day (Oct. 1) and labor day (May 1) in addition to the traditional two weeks off around Chinese New Year (set by the lunar calendar so floats, generally in January or February.) That way everyone had time off to go travel and shop.

I'm drifting off topic here. One last point: a gradual revaluation, if that's what we get, is better for the U.S. as well. A sudden jump would have been inflationary, driving up the price of toys, clothes and low-end consumer electronics. Plus, it would have suddenly devalued all those U.S. T-bills China holds. If China really doesn't revalue any further, or holds the revaluation at too low a level, then look for political pressure to start building again. And people who say this was purely a token move will be justified. They're not justified yet.

BTW, I live in Asia, and currencies are (tangentially) related to what I do for a living, so I have at least some idea of what I'm talking about.

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Thanks very much for this revealing diary, gracchus.  I say revealing because I have to confess I hadn't had the time or need so far to look closely at the Chinese announcement, so my perceptions of it were shaped by headlines.

The significant points in many announcements like this are often in the detail, particularly the detail that gets overlooked by the MSM as they rush to cover the obvious (major) points or the comments of the various interested parties.  The fact the Chinese are allowing a 0.3% trading range on the daily peg does seem to suggest that there will be a gradual revaluation over time, and your analysis of why this will occur, and the consequences, makes sense.

by canberra boy (canberraboy1 at gmail dot com) on Fri Jul 29th, 2005 at 10:55:22 AM EST
There was actually fairly comprehensive coverage of this in the business/financial press. Given who actually runs our society (in terms of real power, no conspiracy theories needed), keeping an eye on business, financial and economic news is important. I'd suggest becoming a semi-regular reader of the FT, Wall Street Journal (just don't read the editorial page, as your hair will catch fire) or the economist (if you can tolerate the snotty english know-it-all right-wingedness). or at least look at the bloomberg, dow jones and reuters web sites every so often.
by gracchus on Fri Jul 29th, 2005 at 11:01:33 AM EST
[ Parent ]
Couldn't agree more.  When I have the time and the access to a copy, my daily journal of choice is the Australian Financial Review, which has this country's best coverage of Oz, regional and global politics (including what's going on inside the government, rather than simply what they've announced), business, and economics.  I find that, given that the owners of capital want real information rather than bullshit, the AFR (or 'The Fin' as we call it) is pretty good on matters like the environment, greenhouse etc.  I used to like reading The Economist despite disagreeing with their line on most issues, but it's years since I had the time...
by canberra boy (canberraboy1 at gmail dot com) on Fri Jul 29th, 2005 at 11:28:22 AM EST
[ Parent ]
Thanks gracchus for posting this. I have collated a number of comments on the topic but have not been able to gel them into a coherent whole. The most interesting one has been Stiglitz's comments in the FT (http://news.ft.com/cms/s/79797f04-fe00-11d9-a289-00000e2511c8.html - probably behind subscription screen, so I post it all below - I'll bend the copyright rules for once)


US has little to teach China about steady economy
By Joseph Stiglitz
Published: July 26 2005

Joseph Stiglitz will answer questions on China, the US and the global economy in a live debate from 3pm BST on August 2. Send questions in advance to ask@ft.com. Answers will appear at www.ft.com/stiglitz

* * *

As excitement over China's revaluation has died down - including jubilation by some of the speculators, who have at last earned an (albeit modest) return - it is time for a calmer assessment about what it does and does not mean for China, for the US and for the global economy.

There remains considerable uncertainty. Though China has demonstrated a willingness to adjust its exchange rate, we do not know what will follow; will the total adjustment over the next couple of years be 10 per cent or 40 per cent? The speculators, surely, will be betting on more. And as China wisely sterilises these inflows, we can expect a continuing build-up of reserves, with this being used by speculators and their allies as an argument for further revaluation. But China will, hopefully, see through this.

The key question is how the appreciation will affect global imbalances, China's trade surplus and the US trade deficit and what, if any, will be the knock-on effects. America's trade deficit of $700bn is nine times China's trade surplus. China's economy has been going gangbusters; rapid growth with little inflationary pressure. The revaluation will hardly make a dent. Even larger revaluations are not likely to do much to the global imbalances.

First, we do not know accurately the size of China's surplus because, in an attempt to circumvent exchange controls, there is over-invoicing of exports and under-invoicing of imports - part of speculative flows. The large import content of China's exports, particularly to America, mean that China's competitiveness will be little affected. Economists disagree about whether the import content for exports to America is 70 per cent or 80 per cent but, whatever the number, it means that the effective appreciation was almost certainly under 1 per cent. In the case of a larger revaluation, Chinese companies would probably respond to the loss of competitiveness by cutting margins, reducing further the effect of the revaluation. This revaluation - even if followed by further moderate ones - is likely only to slow the rising tide of China's exports slightly.

But whether this, or a succession of revaluations, eliminates China's trade surplus will have little effect on the more important problem of global trade imbalances, and particularly on the US trade deficit. Much of China's recent gains in textile sales, for instance, after the end of quotas last December, came at the expense of other developing countries. America will once again be buying from them, and so total imports will be little changed.

More fundamentally, the trade deficit equals capital inflows, and capital inflows equal the difference between domestic investment and domestic savings. That is why, normally, when the fiscal deficit goes up (so domestic savings goes down), the trade deficit goes up. Neither President George W.?Bush nor John Snow, the US Treasury secretary, has explained how China's revaluation will change these basic equations. Unless domestic investment goes down or domestic savings go up, the trade deficit will persist, unabated. The trade deficit could diminish but if it does, it will not be a pretty picture. Domestic investment, for instance, could go down if we succeed in getting our wish and China's trade surplus disappears; with China no longer using the money from its trade surplus to fund our huge fiscal deficit, medium- and long-term interest rates would rise. The economic downturn, and the decrease in investment, would be compounded if the increase in interest rates pricked the housing bubble.

There is a myth of mutual dependence: China needs to export goods to the US, which needs China's money to finance its deficit. But China could easily make up for the loss of exports to America - and the wellbeing of its citizens could even be improved - if some of the money it lends to the US was diverted to its own development. China has huge investment needs. If its government is going to lend money, why not finance its own development? Why not fund increased consumption at home, rather than that of the richest country in the world, to pay for a tax cut for the richest people in the richest country, or to fight a war which most view as anathema? But the US could not so easily make up for the gap in funding without large increases in interest rates, and these could play havoc with the economy.

There is a second myth: that China would benefit from letting its exchange rate float freely, letting market forces set the price. No market economy has foresworn intervening in the exchange rate. More to the point, no market economy has fore­sworn macroeconomic interventions. Governments intervene regularly in financial markets, for instance, setting interest rates. Some market fundamentalists claim that governments should do none of this. But today, no country and few respectable economists subscribe to these views. The question, then, is what is the best set of interventions in the market? There is a high cost to exchange rate volatility, and countries where governments have intervened judiciously to stabilise their exchange rate have, by and large, done better than those that have not.

Exchange rate risks impose huge costs on companies; it is costly and often impossible to divest themselves of this risk, especially in developing countries. The question of exchange rate management brings up a broader issue: the role of the state in managing the economy. Today, almost everyone recognises that countries can suffer from too little government intervention just as they can suffer from too much. China has been rebalancing and, over the past two decades, markets have become more important, the government less so. But the government still plays a critical role. China's particular blend has served the Chinese well. It is not just that incomes have been rising at an amazing 9 per cent annually, and that high rates have been sustained for more than two decades, but the fruits of that growth have been widely shared. From 1981 to 2001, 422m Chinese have moved out of (absolute) poverty.

The US economy is growing at a third the pace of China's. Poverty is rising and median household incomes are, in real terms, declining. America's total net savings are much less than China's. China produces far more of the engineers and scientists that are necessary to compete in the global economy than the US, while America is cutting its expenditures on basic research as it increases military spending. Meanwhile, as America's debt continues to balloon, its president wants to make tax cuts for the richest people permanent. With all this in mind, China's leaders may not feel they need to seek advice from the US on how to manage either the exchange rate or the economy.

The writer is University Professor at Columbia University and was awarded the Nobel Prize in economics in 2001



In the long run, we're all dead. John Maynard Keynes
by Jerome a Paris (etg@eurotrib.com) on Fri Jul 29th, 2005 at 06:31:21 PM EST
Everything Siglitz says may well be right, but I'm also old enough to remember the 1980s, when economists (both left and right) used Japan as a stick with which to beat the U.S.  A little historical perspective may be in order when considering what weight to give this kind of self-flagellation.
by gracchus on Sat Jul 30th, 2005 at 04:47:56 AM EST
[ Parent ]
yes, he certainly has a political agenda (the insider gone progressive and a voice of conscience posture), but I tend to agree with him (and not with the Fed's Bernanke) that the current imbalances are caused by the US's debt fuelled spending binge and not by Asia's saving glut, and that the yuan revaluation will not do much to correct these imbalances.

In the long run, we're all dead. John Maynard Keynes
by Jerome a Paris (etg@eurotrib.com) on Sat Jul 30th, 2005 at 07:47:02 AM EST
[ Parent ]
It is interesting that not much has been made of the well timed Malaysianm release of the dollar peg which was in most likelihood coordinated. The Chinese limited floeat combined with this has led some local analysts seem to think this all points to a combined decision to no longer support the US debt.
By the way all those on KOS etc who thought floating the Yuan would reduce teh trade imbalance and create US jobs were off their trees. Not long ago Standard Chartered were saying that even a 20% revaluation would not create one job in the US, and that the US had to learn it was no longer compaetetive in many sectors.
by observer393 on Sat Jul 30th, 2005 at 03:05:53 AM EST
Unclear if there was any coordination. Malaysia's depegging was awaiting the yuan's depegging (competitive reasons), and was probably overdue by a year or two. The Beast From the East (Bank Negara Malaysia) may have gotten a head's up from the People's Bank of China, or may simply have been ready to act and put their plan into immediate effect after reading about the Chinese revaluation on Bloomberg or Reuters or what have you.
by gracchus on Sat Jul 30th, 2005 at 04:44:59 AM EST
[ Parent ]
I read somewhere (was it in your thread over at kos?) that the Chinese got the representatives of the main international banks together, locked the doors, took away mobiles and blackberries, and informed them a few hours before the official annoucement of what was coming. It is pretty likely that they did the same with the authorities of a few countries.

In the long run, we're all dead. John Maynard Keynes
by Jerome a Paris (etg@eurotrib.com) on Sat Jul 30th, 2005 at 07:52:46 AM EST
[ Parent ]
It could well be true. But I really wonder what advantage a very brief heads-up like that is when you can't act on it, apart from the gloat factor of knowing you knew earlier.
by gracchus on Sat Jul 30th, 2005 at 09:13:26 AM EST
[ Parent ]
The formal announcement by Malaysia was within minutes of that of China and the accompanying release was a well prepared document, as opposed to a rushed one, leading most to conclude that it had been coordinated.
by observer393 on Sun Jul 31st, 2005 at 03:12:00 AM EST
[ Parent ]
It was certainly prepared...and may have been prepared for a couple of years. So it may simply have been a matter of hearing the news, changing the date on the release and sending it out. I'm not saying it wasn't coordinated with China, just that it didn't necessarily have to be. Wouldn't surprise me either way. I'll make enquiries on Monday with some people I know in Malaysia to find out what they've heard.
by gracchus on Sun Jul 31st, 2005 at 06:10:24 AM EST
[ Parent ]
Thanks to all for a very informative thread and very acute observations. To me it's interesting how moral judgments (which, I tend to share) are closely interwoven with "objective" analysis: the spendthrift inequities of American economic policy placed in stark contrast to China's continuing economic miracle. If Stiglitz is right, raising almost half a billion people out of poverty in about 30 years is really something to crow about, and, not coincidentally I'd say, all this without recourse to war (except for the invasion of Vietnam at the beginning of the Deng Tsiao Ping era). I hope someone will pick up the by now familiar counterpoint provided by India too. Of course, many of the views expressed here rely only on other opinions and on statistics, not on personal experience. Presumably statistics are better than "seat of the pants" anecdotical experience, but one never knows for sure when one is living in a dream world. Moreover, the obviously increasing and tangible presence of Chinese goods in occidental markets seems to give experiential weight to the "statistics". What remains questionable is our ability to extrapolate from these empirically verifiable trends.

Hannah K. O'Luthon
by Hannah K OLuthon on Mon Aug 1st, 2005 at 05:41:34 AM EST


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