Commentary: Should China Revalue? Soon, It May Have No Choice

The debate over revaluing the Chinese yuan is gathering steam. For weeks, everyone from Fed Chairman Alan Greenspan to U.S. Treasury Secretary John W. Snow to European Central Bank President Wim Duisenberg have been warning of the consequences if Beijing does not revalue its currency, which at its current fixed rate of 8.28 to the greenback may be undervalued by as much as 30%. Many in the West argue that the Chinese, by keeping their currency artificially cheap, are ruining other nations' ability to compete in global trade and building up a dangerously large foreign currency reserve. Chinese officials, politely but firmly, have basically told the West: Get lost. China's domestic economy needs to soak up millions of jobless workers and recover from the ravages of SARS. Cheap exports are vital in this exercise. No way is a major revaluation possible.

A stalemate? Seems like it. But the political exchanges may send confusing signals concerning which way the yuan will really go. Don't fixate on the high-level chatter of the world's finance ministries. Rather, look at what ordinary businesses and individuals in China are doing -- that is, at the day-to-day flow of money across China's ever more porous border. In this realm, stockbrokers, fund managers, corporate executives, and currency traders are all betting on a revaluation by pouring money into the country. The very weight of all this money will force officials to act, analysts say, or risk unbalancing China's domestic economy. "Distortions are accumulating," warns Yiping Huang, a Hong Kong-based economist at Citigroup (C ).

What money bears watching in this game? The most familiar indicator of a currency problem is the rapid buildup of foreign reserves due to an imbalance between imports and exports. And China certainly has that, with reserves of $346 billion, including a current-account surplus of $100 billion just over the last 12 months. Another $10 billion is added every month.

This buildup partly reflects the steady flow of foreign direct investment. But reserves are building in part because of another number: something called "the errors and omissions" item in the balance of payments statistics that the Chinese government, like every national government, publishes every year. The balance of payments exercise is simply a bird's-eye view of overall flows of money into and out of a country. In this exercise, central banks compile data from government sources of the officially recognized payments and receipts that a country's companies and investors generate in cross-border transactions. If the numbers show more money going into or out of a country than the official stats suggest, then it records that sum in the errors and omissions category, which exists simply to balance out any discrepancies in the data. This category is also the best proxy for showing the existence of underground, cross-border money flows that a government cannot detect.

In China's case, the errors and omissions category showed a steady flight from yuan-denominated assets from 1990 to 2001. What was happening? Many Chinese wanted to skirt China's strict currency controls and get their money out of the country, whether to give extra spending money to children studying abroad or to spirit out ill-gotten gains. So they moved their yuan elsewhere. Throughout the '90s, thousands of mainland Chinese literally carried suitcases of money into Hong Kong. They converted the cash into Hong Kong or U.S. dollars, or Hong Kong real estate and stocks.

The slow, steady leak of money out of China indicated that even the Chinese thought their money was safer in other currencies. All told, errors and omissions added up to $136 billion between 1989 and 2001. Some analysts think it was much more, especially during the 1998-99 Asia financial crisis, when capital flight is thought to have totaled $30 billion to $40 billion annually, double the amount shown in the errors and omissions category.

In addition, legitimate Chinese companies sidestepping foreign exchange controls often doctored invoice statements to show that they had paid a foreign supplier or partner more than they actually had. The companies then siphoned off the difference into offshore accounts.

But a notable change is happening in these flows. Just look at the recently published balance of payments data for 2002. Last year China recorded a net surplus in its errors and omissions cash flow of $7.8 billion, a stunning reversal after years of outflows. Some traders think the money flowing in may be much higher than that. "People are bringing more money into China than they otherwise would," says Citigroup's Huang. One reason black money is rushing back in is that Chinese companies and individuals see better ways of making money in the mainland than elsewhere (Hong Kong real estate stinks). But, say traders, it's also a sign that many are expecting the yuan to be revalued. So buy yuan now, enjoy a big appreciation later. "Everyone knows that the [yuan] will go up," says a currency trader in Beijing.

It's not just Chinese making this bet. Take the latest development in those mainland bourses where only domestic investors were allowed to trade. Foreign institutional investors have just gotten the green light to buy and sell so-called A-shares -- and they're poised to spend billions of dollars on these stocks. Funny thing is, mainland-traded stocks aren't very attractive; they're both overpriced and the companies behind them are anything but transparent. The foreign banks, by bellying up to buy A-shares, can show their commitment to China, which is good for business. But betting on a currency revaluation sure makes the buy decision easier. Says one Western investment banker in Beijing: "China is likely to revalue in the next six months." Buy shares with cheap yuan now, and six months later the gain on the currency alone might justify the trade -- or provide a hedge against a stock's slump. The same thinking now affects the calculations of most foreign investors, whether it's a new plant or a venture-capital foray.

The bet on revaluation may be a self-fulfilling prophecy. All the money rushing into China distorts the domestic economy, and that's what could force the government to take action. Because China limits foreign currency holdings, the central People's Bank of China must buy such currency from Chinese companies and individuals. They in turn spend much of the newly minted yuan on real estate, which is beginning to get overheated. The People's Bank is trying to limit the impact of this massive money injection by selling bonds, which soak up liquidity. But this so-called sterilization of the currency inflows can't continue indefinitely. If foreign money continues to stream in, bond issuance to soak up the money could get out of hand, making the interest alone on the bonds a drag on government finances. "They should make a change quickly," says Huang. "Otherwise, you build up many more distortions, and it makes it much more difficult for macro policy."

For businessmen and currency traders, Beijing has only one way out of the trap: a revaluation upward that makes the yuan more expensive, which in turn stops the money rush by making consumer goods, property, stocks, and everything else more costly. Beijing may not listen to Greenspan, it seems. But the slow, steady pressure of the markets is another matter.

By Mark L. Clifford

With Dexter Roberts in Beijing

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