April 26 (Bloomberg) -- Alan Greenspan has once again missed the point about what's going to unfix the pegged Chinese currency.

``They're going to have to, for stability's purposes, move their currency,'' the U.S. Federal Reserve chairman told a Senate Budget Committee in Washington last week.

The People's Bank of China buys incoming dollars and adds them to its $659 billion official reserves in order to keep the yuan steady at 8.3 against the U.S. currency; it sells bonds and bills to prevent an inflationary surge in money supply.

According to Greenspan, it's this second step that's now showing signs of instability. ``Because there are interest rate caps in China,'' he testified, ``they're finding some difficulty in selling an adequate amount of domestic currency-denominated debt to absorb the excess'' liquidity.

The Fed chairman is correct to focus on the effects of an undervalued yuan on monetary management in China even as political and business interests carry on a pointless debate that insists on discussing yuan ``manipulation'' in the narrow context of the $162 billion U.S. trade deficit with China.

Laudable as his objectives are, Greenspan is overlooking facts, or interpreting them too liberally, to suit his arguments.

`Sterilization' Debt

In theory, Greenspan is right about the central bank ``finding some difficulty'' in selling debt. However, the theoretical premise has been turned on its head in China: Not only is the central bank selling more of the so-called ``sterilization'' debt, it's doing so at lower yields. The banks that are buying the debt appear to be oblivious to the risk of inflation accelerating in the months ahead.

In the first week of April, the Chinese central bank sold 20 billion yuan ($2.4 billion) of three-year treasury bills at 3.2 percent. In the second week, when it raised the amount to 30 billion yuan, the yield fell to 3 percent. In the third week, it increased the amount once again, to 35 billion yuan. The yield rose very marginally to 3.1 percent. That's still 1 percentage point lower than in January.

With inflation in China at 2.7 percent in March and expected to rise, the only reason Chinese banks are buying treasury bills at such low yields is because they are extensions of the communist state. China's big four state-run banks accounted for more than half of the banking system's assets of 31.5 trillion yuan last year.

Yuan Debate

This game can go on until the top four banks, which had $188 billion of bad loans at the end of September, or 15.7 percent of their total lending, are made truly independent.

``In countries where the banking system is under government control and interest rates aren't market-determined, such as China, the quasi-fiscal expenditure (of sterilization) has been largely offloaded onto state-owned commercial banks that have been required to purchase securities sold by the People's Bank of China at below market-clearing interest rates,'' said a recent World Bank report.

In the past too, Greenspan has obfuscated the yuan debate more than he has helped illuminate it. He said at Stanford University's economic summit in February 2004 that it was ``fairly reasonable'' to expect the yuan to rise, driven by the ``sheer basic underlying momentum of productivity.''

It's true that workers in China's export-oriented factories, as they become more productive, will take home bigger paychecks, which they will then spend on services that aren't normally exported. As barbers and pet shop owners earn more without a corresponding increase in their productivity, local Chinese prices will rise.

Productivity Ruse

A flexible yuan would achieve the same adjustment between the relative prices of tradable and non-tradable goods through a stronger currency, rather than higher inflation.

The trouble is that with the existence of several hundred million excess workers in China's countryside, it may be decades before a rise in export productivity leads to matching wage growth.

Expanding on the productivity theme, Greenspan told the senate committee last week that China will embrace a stronger yuan because a weak currency ``prevents standards of living from rising.''

This too is a lame reason. Asian mercantilism is all about sacrificing the present for a prosperous future. It makes possible, and is in turn made possible by, the extravagance of the U.S. government and consumers who are equally adept at doing just the opposite: sacrificing the interests of tomorrow's taxpayers for their financial excesses today. Why should China alter its present before the U.S. rethinks its future?

Greenspan Is Key

Greenspan's analysis of the yuan was -- and is -- an Economics 101 lecture; it adds nothing new to what the market already knows.

``I have no way of projecting when they will move,'' the Fed chairman told the senate committee, summing up his arguments. ``That they will move -- I am reasonably certain.''

And that article of faith is the crux, really. The point that Greenspan has missed in the yuan debate is a simple one. The Fed chairman's words and deeds matter more to China as it makes up its mind about yuan flexibility -- not a surge in productivity or any difficulty faced by the Chinese central bank in selling bonds.

By linking their currency to the dollar, the Chinese have imposed U.S. monetary conditions on an economy that's very different. As a result, money is much too cheap in China. The central bank's benchmark one-year lending rate is 5.58 percent.

Speculators

That's causing the Chinese economy to overheat, as the first quarter's 9.5 percent growth in gross domestic product indicates. For China to raise interest rates faster than Fed is fraught with difficulty as it may invite stronger inflows of speculative capital into China.

Speculators put their money where Greenspan's mouth is. That includes Shanghai property whose prices have shot up 19 percent the past year. It doesn't matter why Greenspan thinks what he thinks. If he says the yuan will move ``sooner, rather than later,'' speculators will ensure that China gets such a deluge of dollars it has no option except to move -- sooner, rather than later.

To contact the writer of this column: Andy Mukherjee in Singapore at amukherjee@bloomberg.net.

Last Updated: April 26, 2005 00:37 EDT