The yuan peg creates artificially cheap prices and unnaturally low borrowing costs for the US
China's US Treasuries purchases are deadening the US's need to address its current account defecit
A large one-off adjustment could be destabilizing. Allowing a gradual, measured appreciation would result in more balanced trade globally
In the year to 30 September, while the world economy descended into the deepest recession in generations, China grew an enviable 8.5% (IMF, October 2009). Now, though, critics of this policy are growing restless. China should loosen its currency reins in 2010, they say. When it does, the impact will extend beyond China and trade.
THE US GOVERNMENT has long pushed for a flexible yuan. In 2005, Congress targeted China with a “Currency Manipulation Prevention” bill and a 27.5% import tax. In contrast to those measures, recent efforts look weak. Washington vernacular has eased from “manipulation” to currency “misalignment.” In a post-crisis world, a soft stance may be deliberate. The peg creates alluring near-term benefits for the US in the form of artificially cheap prices and unnaturally low borrowing costs. If the yuan appreciates, US consumers must either pay more or pare back.
The impact on interest rates is even greater. Maintaining the yuan peg forces China to buy dollar-denominated assets – usually in the form of Treasury securities. Because bond prices and yields move in opposing directions, when demand for Treasuries is high, yields fall. When yields fall, the cost of financing the massive US public debt drops. Recently, despite the largest Treasury auctions ever, yields have scraped record lows. To a certain degree, China’s currency regime is helping fund America’s economic recovery.
Private-sector borrowers are also benefiting. Treasuries establish a price point for consumer and business loans. When interest rates drop, the break-even threshold on capital investment falls. For businesses, some projects that would not otherwise be profitable become so. For consumers, rate-sensitive products such as mortgages become more affordable. This is helpful for a nation digging out from a housing bust.
NOTHING IS FREE. US exporters rightly argue that China’s currency policy puts them at a disadvantage. The Big Mac Index, a guide to currency valuations devised by The Economist, puts the yuan at 49% undervalued compared to the greenback. Comprising 9% of total nonfarm payrolls, manufacturers account for more than 30% of US jobs lost since December 2007.
Addressing US export concerns would help resolve one of the world’s largest economic imbalances: the US current account deficit. As a nation, the United States spends far more than it receives. The resulting gap – the current account deficit – is covered by foreign capital.
Current account reversals can be brutal, typically resulting in “large declines in GDP,” according to the US National Bureau of Economic Research. Horacio Valeiras, chief investment officer of Allianz Global Investors Capital (an independently operated unit of Allianz Global Investors), contends that China’s Treasuries purchases deaden the discipline required to solve America’s current account problem. Individuals can’t sustainably live beyond their means – the same holds true for nations.
A final rationale for de-pegging resides within China. The yuan peg connects China to American monetary policy, which is designed for a developed country in the midst of recession. As the world’s fastest growing major economy, a tighter monetary jacket would fit China better.
Officials at the World Bank and International Monetary Fund have cautioned on speculative bubbles in east Asia. Some may be forming. The Shanghai A Index – a benchmark for locally owned shares – powered to an 80% gain in 2009, more than triple the advance in the US’s S&P 500. Last July, The Economist reported up to 20% of Chinese bank loans were being funneled into the stock market.
THE YUAN PEG facilitates risky economic imbalances. It also has diminishing returns for China. Chinese growth during the first nine months of 2009 was based entirely on domestic demand, which contributed 12% to GDP. Net exports subtracted 4%. Trade’s impact may have been worse without the peg, but annual growth beyond 10% risks stoking inflation.
It is unlikely China will yield to currency bullying. De-pegging will be done on China’s terms, and method is as significant as timing. A large one-off adjustment could be destabilizing, crushing exporters and locking in losses on China’s US holdings. Jean-Claude Junker, head of the group of euro-area finance chiefs, suggests a more gradual and orderly appreciation. He is right. The result will be more balanced trade globally and substantial opportunity for bottom-up stock pickers.
Published by PROJECT M in April 2010
(Photo: www.saengerphotodesign.de)
