Sunday, May 22, 2005

Chinese Yuan Revaluation - Why

In last few weeks there has been rumors that Chinese government is under pressure from US and EU to reevaluate their currency. Currently their currency is undervalued 15-40%. What that means to a lay men is that their exports in US and other countries are very cheap as 1$ (US) can buy more Yuan at current price, which is 1$(US) = 8.27 Yuan. But if it evaluates then 1$ (US) will give you less number of Yuan, that means that US dollars purchasing power will decrease, that is, Chinese export becomes expensive in US and other parts of the world and US companies mostly which have invested heavily will get more US dollars from profits made in China. Other thing to keep in mind here that Chinese do business in US dollars only! rather than in any other currency, which means, for EU it is more serious issue, because Euro has appreciated as compared to US dollar in last 3-4 year. That has lead to cheaper Chinese export in Europe because the trading is only in US dollars. That's why there is a lot of pressure from US and EU on China to reevaluate their currency. Currency is China is controlled by government unlike US and EU, and Australia where it is controlled by market.

With this background in mind, Economist writes in it's article What do yuant from us?
Quote :
Both the European Commission and the American Congress have begun proceedings to protect their citizens from the threat of cheap Chinese textiles. Both are unhappy with the effect of Chinas currency peg to the dollarAmerica because it makes inexpensive Chinese goods even cheaper, and Europe because the euro is having to bear the brunt of the dollars depreciation. On Tuesday May 17th, America's Treasury gave warning that unless China relaxes its peg, it is likely to be classified as a currency manipulator. In Congress, a proposal is afoot to slap punitive tariffs on Chinese goods unless the yuan is revalued within six months. Such moves are sufficiently worrying that on Friday the official Xinhua news agency reported that China would impose export tariffs on its own textiles starting in June, presumably to ward off more draconian measures abroad.

Certainly, the head of Chinas central bank has recently been making noises that sound an awful lot like revaluation. But other officials are reluctant to tamper with a peg that they perceive to be working well. This week Wen Jiabao, Chinas prime minister, thundered that his country would not bow to outside pressure on the yuan. Indeed, many think that hotter rhetoric from American politicians will only make China delay any revaluation plans it is working on. Having enacted export tariffs in response to protectionist politicians on both sides of the Atlantic, China might now be even more reluctant to relax its peg, for fear of being seen buckling under foreign demands.
Revaluation certainly looks tricky for the Chinese government. It believes that for the sake of political and social stability, it needs 15m-20m new jobs a year. Increases at that level will be enough to absorb population growth, plus displaced workers from the agricultural sector and Chinas ailing state-owned firms. And the export sector is seen as a crucial vehicle of job creation.
But this is not the only reason that Chinese politicians are reluctant to revalue. By some estimates, as much as three-quarters of Chinas foreign-currency reserves are held in dollars; if the central bank allows the yuan to rise against the dollar, it will also in effect be allowing the value of its reserves to depreciate. Moreover, if slowing the flood of dollars that Chinas central bank is pouring into American debt markets does cause those markets and the American economy to contract, Chinas exporting firms will have worse problems than a more expensive yuan. And problems for those firms could translate into big trouble for Chinas frail banking system.

Nonetheless, China seems to be preparing the way for a slightly freer currency. This week it allowed some foreign currencies to be traded against each other for the first time in China. This is widely seen as a preparation for reform of the tightly controlled currency regime. And if a revaluation seems unlikely to please Americas protectionist politicians, it should nonetheless help to correct the imbalances caused by the gaping American current-account deficit, if only by weaning Americas spendthrift consumers and government off cheap Chinese credit. If the hour of reckoning is not quite at hand, it seems only a matter of time before Chinas financial system, and Americas borrowers, begin to grow up.

Before this story in Economist, Lawrence Kudlow writes in his blog about, that US blunder is in making, when it comes to China and it's monetary policies of controlling their currency under "Blundering on China".
He writes, quote :
Since 1994, when China instituted a quasi currency board system, the Chinese economy, linked to the greenback as its reserve currency and standard of value, has created more prosperity in that huge country than at any time before in its history. Since 1994, real growth of gross domestic product in China has averaged about 9% a year. During this time, in a country previously plagued repeatedly by unreliable money and a volatile but usually high inflation rate, the Chinese consumer price index has risen only slightly above 3% a year. Japan would die for this kind of economic performance. So would Western Europe. Why would anybody in his or her right mind wish to meddle with this kind of economic performance.
Just ask the other developing economies in the Pacific Rim. Neither Free Korea, nor the Philippines, nor Thailand, nor Indonesia, nor Malaysia can boast of this kind of track record. Turn the clock back to 1997 and 1998. All those aforementioned countries were pegged to the dollar and enjoying solid prosperity. So what happened? Robert Rubin's Treasury, along with the geniuses at the International Monetary Fund, decided that these countries should float their currencies and de-link from the U.S. dollar. What happened? The currencies promptly sank.
There's a lesson here. It's a simple one. Emerging currencies don't float. They sink. Why is this? Because they have a history of instability. They do not have a history of monetary value that is reliable. That is why the dollar link was correct in those days and that is why the consequences of this currency meddling by the IMF nearly threw the world economy into a deflationary spiral. And those countries suffered the most, as foreign investment flows were immediately withdrawn. As such money left those countries, their economies shrank, unemployment rose, and in many places there was rioting.

It will be seen in coming months what Chinese government do, whether it takes a firm stand or bow down to US and EU pressure. As far as what will be it's consequences in Australia I wrote this entry, Chinese currency - yuan's revaluation - After effects, on my blog few days back.

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