China’s currency conundrum

OVER THE PAST few months China has come under intense scrutiny because of its undervalued currency. Unfortunately for China’s leaders, as US politicians prepare for the 2004 presidential elections they realize that attacking China continues to sound a chord with their domestic audience. They are blaming it for US job losses, ballooning trade deficits and other economic ills. The accusations will not die down soon. And it doesn’t seem to matter that many of the arguments are severely flawed.

At a meeting in July with the CEO of a global investment bank, Chinese premier Wen Jiabao (pictured above) was advised to steel himself for intensified criticism in coming months. “We emphasized that the US was gearing up for presidential elections in 13 months’ time,” says the bank’s head of its China operation, who was privy to the conversation between his boss and Wen. The chat was a warning that despite China’s leaders making it clear that there would be no revaluation of the renminbi in the short term, the mudslinging and finger-pointing from the US would become more frequent and more virulent in coming months.

But Wen is “ready for it”, according to the bank’s country head. “The premier knows that there will be a lot more controversy surrounding the currency and revaluation. And he understands that many of the comments coming out of the US are being made for political reasons. He’s also clear that there are pockets of very vocal people saying things who don’t really have a clue.”

The recent build-up of international pressure for revaluation can be attributed to US Treasury secretary John Snow. Although he only picked up the message from a surprisingly agitated and noisy Japan, it was Snow who suggested publicly in July while visiting factories in Milwaukee that the Chinese should reconsider their exchange-rate regime and make it more flexible. He pointed to the surge in China’s foreign exchange reserves – $60 billion so far this year – as evidence that the currency is being kept artificially low.

“Snow needs to be more careful,” says another senior banker based in Shanghai. “His comments suggesting a more flexible currency regime in China may well have been reasonable, but others who are less well informed read so much more into them.”

US Federal Reserve chairman Alan Greenspan fanned the flames further when he argued that China would not be able to keep the renminbi pegged at 8.28 to the dollar indefinitely. Many believe that such observations were, as the senior banker says, tantamount to telling the Chinese that they should allow their currency to appreciate immediately.

To those demanding an immediate revaluation of the renminbi the arguments are simple: by being pegged to the dollar China’s currency has become far too competitive given the dollar’s recent decline against other currencies. The protagonists argue that you only have to scan the numbers for proof. While the industrialized world’s GDP growth is limping along at 1.5%, China’s is hitting 7%. In addition, its industrial output has surged 16.9% year on year and exports are up by 32.6%. China, the critics say, is unfairly vacuuming up a large share of the global export market at the expense of other nations, in particular the one with the loudest voice, the US.

In addition, commentators in the US highlight the fact that the US trade deficit with China is now as high as $103 billion and increasing by 25% a year. They also claim that China’s policy of maintaining a weak exchange rate has so far cost 2 million American jobs in manufacturing, with more expected. Tim Condon, ING’s chief Asia economist, says: “The recovery in the US won’t really be complete without a strong turnround in the manufacturing sector. And to do that the dollar needs to weaken further.” But as Condon points out, the dollar isn’t going to weaken further against the euro or Latin currencies. “The big place that does not allow its currencies to strengthen against the dollar is Asia. But you won’t see a move in dollar-Asia until the renminbi and dollar are revalued.”

Industrial lobbying In an attempt to protect US producers from being steamrollered by imports from Asia, and especially China, industrial lobbyists, such as the pressure group Coalition for a Sound Dollar, which represents over 80 industrial and trade associations, are demanding that Washington twists China’s arm to get it to revalue.

Helping them out and seemingly happy to join the bandwagon are Democrats looking to score political points. In the run-up to elections opportunist politicians will say anything in an attempt to placate sectors of the electorate – in this case domestic manufacturers tired of seeing products labelled “Made in China” swamping the country – and win easy votes. As Dong Tao, CSFB chief economist for non-Japan Asia, says: “In an election year when things are not going well, foreign exports are very easy to blame.” Fred Hu, Goldman Sachs’s chief China strategist, agrees: “All these quarrels are being driven by domestic politics. But if the US economy was to pick up it would alleviate a lot of the pressure on China.”

Jonathan Compton, chairman and UK and global fund manager at Bedlam Asset Management, worries about the potential unintended consequences for global equity markets of the US becoming preoccupied with the transfer of productive capacity to China and the hollowing out of American jobs. “Given the huge ideological differences and the fact that America and China tend to compete in the same export markets, it is a sure bet that one of the key issues for all presidential candidates will not be Iraq, al-Qaeda or Jacques Chirac, but how to deal with the Chinese ‘menace’. It will be about protectionism.”

There is, of course, an element of hypocrisy here. Some US corporations that belong to these trade groups have for years happily shifted production to countries with cheap labour, such as Mexico, Brazil and India, to boost earnings. Americans have benefited through cheap goods and healthy stock market returns.

But the world has never seen anything like the shift of production to China that has been accelerating over the past five years.

And the debate and ill-feeling towards China does not end at the US customs gate. There are also those in Japan who are equally irked. The staid political old guard protests that China should shoulder much of the blame for Japan’s protracted economic slump. Even finance minister Masajuro Shiokawa has come out and said that an undervalued renminbi is the key driver of China’s gain in the global export market and responsible for exporting deflation to the world – in other words to Japan.

The markets, say the Japanese, should be allowed to work so the renminbi can find its natural level.

Again, such talk smacks of hypocrisy. After all this is the country that spent a record $38.4 billion in the three months to June weakening the yen. Dong Tao says: “It’s ironic that Japan is making such arguments. This is a country that pours billions of yen into the market to stabilize its own exchange rate. And whenever it gets into trouble it uses its exchange rate at the cost of its neighbours.”

Treasury secretary Snow, apparently a strong proponent of market forces when it comes to the Chinese, has so far failed to censure the Japanese. Other economists believe that Japan is tired of looking at itself in the mirror and is now merely attempting to deflect attention and blame away from woes of its own making. Frank Tong, Bank of America’s chief China strategist based in Hong Kong, says: “Everyone knows that Japan’s deflation was caused by Japan and not by the renminbi. A revaluation of the renminbi will not solve Japan’s deflationary issues.”

But if the renminbi is recognized by all parties, including the Chinese, as being undervalued, why don’t the Chinese simply allow it to rise in order to stop the international squabbling?

For a start the Chinese see this as a domestic issue not an international one, and resent being so publicly criticized. As the Chinese government said in August through its mouthpiece, the People’s Daily, domestic priorities such as job creation and social stability outweigh other concerns. It should also be remembered by those so quick to pass judgement that China is pursuing its pro-market economic reforms as fast as it can, but it won’t change at a speed that could cause social instability. Condon says: “The revaluation of the renminbi will increase pressure on the marginal exporters. And that could lead to social tension and so slow down the reforms. It’s a real conundrum. China is having to balance competing objectives.”

So the situation as it now stands is a deadlock. The Chinese refuse to back down. And the Americans and the Japanese refuse to stop the barracking for action. The fear is that strong words could turn into rash action and the US could decide to resort to good old-fashioned tariffs and price barriers to force China’s hand. A globally damaging economic trade war, say the pessimists, could be imminent. Already, they claim, US manufacturing industry is banging the drum and demanding that the government use section 301 of the Trade Act of 1974. This allows the US government to take action against competitors that it believes are using unfair trading practices. Such a response normally involves protectionism.

But before taking such action the US administration needs to balance the demands of the frustrated flag-waving voter and the fact that it needs China. In foreign policy for example, the US judges China’s presence in talks about North Korea’s nuclear arsenal as crucial. And China could also threaten the US economically. If pushed hard enough it could indicate that it would reduce its buying of US treasuries and US agency debt. The results, if China were to put the brakes on such purchases hard enough, would be more than a minor irritation. The US dollar would be hurt further, US interest rates would rise and government borrowing costs, as well as those of Fannie Mae and Freddie Mac, would shoot up.

With such actions open to the Chinese, the US government knows that it would be unwise to take any immediate action that could be construed as hostile. So the stalemate looks set to persist for the time being.

Hopes for an agreement However, some economists hold out hope that a resolution will come sooner rather than later. “The Chinese will revalue. And the way it will come about will be much the same as happened in 1985 and the Plaza Accord,” says one economist. In that year James Baker summoned finance ministers from the industrialized nations to the Plaza Hotel in New York and explained it was either dollar weakness or protectionism. “I think that there will be a similar behind-doors agreement,” says the economist. “And Asia will allow their currencies to strength against the dollar.”

One banker offers another suggestion about how such an impasse might be broken: “China needs to sort out its PR machine,” he reckons. “It needs to make clear that many of the beliefs held about it are misconceptions. This will turn down the heat.” It’s a feeling that many economists, strategists and analysts share. While they believe that China should at some point liberalize its exchange rate, they understand that it is for now being unfairly accused.

Much of China’s export boom is not of its own making but a result of outsourcing and investment by multinationals from the very countries that are demanding a change in the exchange rate. With manufacturers worldwide desperate to lower costs and enhance profitability, in 2002 $52.7 billion of foreign direct investment flowed into China to be spent on such projects. The country was the largest recipient of FDI in the world. And according to statistics from Morgan Stanley, from 1994 to June 2003, while China’s exports tripled in value, from $121 billion to $365 billion, 65% of the increase can be attributed to global multinationals and joint ventures between Chinese and foreign partners.

As Stephen Roach, Morgan Stanley’s chief economist, says in his report The Scapegoating of China: “China’s increasingly powerful export machine has America, Europe and Japan stamped all over it.”

Japanese misconceptions Furthermore, while the Japanese are being particularly vocal in suggesting that the undervalued renminbi is consuming Japanese jobs and pushing it into deflation, its own companies, such as Mitsubishi, Nissan and Canon, have experienced growth rates in China as high as 20%. This in turn has dramatically helped their bottom lines. Add to this the fact that Japan is now running a $24 billion surplus with China and its arguments for an immediate revaluation seem all the more confusing.

Joan Zheng, JPMorgan’s chief economist based in Hong Kong, says simply: “China is growing and the Japanese feel threatened.” She adds that Japanese politicians only concentrate on the low-end manufacturing jobs. “But if you move beyond these jobs that are being lost you have a very different view. And it allows the Japanese to specialize in what they are good at, which is why they are growing non-manufacturing jobs.”

China’s massive trade surplus with the US has continued to colour many opinion-makers’ perceptions. They see the $103 billion bilateral trade deficit and start crying foul, refusing to look at the equation in any other way. Those that so openly criticize China fail to see that while its exports have been increasing rapidly, its imports have been growing even faster.

In 2003 imports increased by 45%, shrinking its trade surplus by 70%. China’s trade surplus now stands at just 2% of GDP. And even that figure could vanish into the red as early as next year. In the first quarter of this year it did just that and for the first time in eight years China ran a trade deficit. Much of this can be accounted for by the bilateral trade deficit that China has with most of Asia. As ING’s Condon says: “If you look at the currency and exchange rate through the prism of just the trade balance with the US, it’s the wrong way to do it. It’s just not correct to say that China is following a mercantilist policy of only running a trade surplus. That argument does not hold any water.” The truth is that the US doesn’t make certain goods any more. China does. And if the US consumer didn’t buy them from China then they would be purchasing them from somewhere else, running up a similar deficit.

Much attention is also directed at China’s hoarding of foreign reserves as a reason for it to get its exchange rate in line with the US view. As Snow himself pointed out, if China has already accumulated over $60 billion in foreign currency this year alone then this is proof enough that the currency must be severely undervalued.

However, this argument again fails to look at the entire picture. Of the $60 billion, $6.9 billion was because of its trade surplus and $26 billion came from FDI inflows. Just under $30 billion is unaccounted for. Perversely those that are pressuring China to mend its ways and revalue its currency are possibly causing such inflows. Speculators are starting to take punts that China will at some stage give in to international pressure and change the value of its currency. If politicians get their way and force a rise in value of the Chinese currency these speculators might win their bet.

In the early 1990s there was $15 billion of illegal outflow of funds. Now China is having to deal with an unusual and large illegal inflow of funds. As Frank Hong, ABN Amro’s chief strategist in Asia, says: “The mainlanders used to use a briefcase to take the money out of China to Hong Kong. Now they are taking the money back in again. The only difference is that now they use a Dunhill brief case.”

Zheng from JPMorgan says: “The change of expectations about the renminbi value from depreciation to appreciation has not only discouraged flight from China but also encouraged speculative flows to China from the rest of the world. And while it’s true that the renminbi is not convertible for capital account activities, this does not mean China can effectively limit hot-money inflows.” Zheng claims that China has, until now, only had to focus on controlling the money that was flowing out of the country not money flowing in.

Over-eager speculation The cash may be just a bit early flowing in because most economists in the region don’t believe the Chinese will capitulate this year. The popular view is that something will happen in the second half of next year. The question that many, including the Chinese, are asking, however, is how the currency question can best be addressed. That’s because contrary to the claims of US politicians and Japanese economists, the Chinese have for some time been aware of the need for a more flexible foreign exchange regime.

The Chinese will continue to study the differing options available. At the forefront of their minds is fear that any sort of revaluation or appreciation will only bring about greater pressure for yet further appreciation. For now, everyone is second-guessing what China’s planners will decide. Views range from a gentle widening of the band that the renminbi trades in to a quick, sharp shock revaluation of between 15% and 20%.

Those of the latter mind think that China can easily afford to let the currency appreciate by 20%. As Hong from ABN Amro explains: “All that will happen is that exporters will raise their prices by 20% in dollar terms. But also remember that 50% of exports are by foreigners, not by Chinese, and they import a lot of raw material from other countries. So if the currency appreciates then the import prices will drop, which means that they don’t need to raise their prices by 20% at all. Even if the price does appreciate then China’s exports will not become less competitive.”

Hong is sceptical of the view that the renminbi’s trading band should be widened. He says this will only put more pressure on the currency. He feels that those Chinese citizens and corporates that are holding over $150 billion of foreign-currency deposits would look to buy renminbi if they began to think that the authorities were going to let the currency appreciate yet more. The floodgates for hot money could be opened and China could lose control of its economic management.

Hu at Goldman disagrees with the premise that China should revalue, although he believes the Chinese should move toward greater flexibility. “Revaluation is not the way to go,” he says. “It assumes that you choose another level and peg it there.” As he says, the issues of today could easily arise tomorrow. And what is important is making sure that the currency remains stable, so putting off speculators from attacking it.

“The Chinese financial system is weak and cannot withstand unfettered moves of capital cross-border and offshore. But a relaxation of the draconian rules that are now in place can be done gradually. And it definitely needs to be done,” says Hu. “Widening the band will not have a huge effect on China’s exports and China cannot ignore the comments coming out of the US. While some form of protectionism is very extreme, it’s in China’s interest to move toward a flexible exchange rate sometime soon. Market access is more important than the exchange rate.”

The Chinese are hoping that US recovery kicks in soon to dampen down all the criticism. They hope this will then reduce the number of gamblers looking to make a quick buck on the currency’s future.