Drowning in Dollars

It's a problem for China, but is revaluing the yuan a wise move?

For years, Shanghai mortgage broker Linda Liu happily parked most of the money she saved while living in San Diego in U.S. securities. But lately she has been hearing rumors that China will revalue the yuan, which for nine years has been pegged at 8.28 to the dollar. Some analysts figure the yuan could appreciate up to 30%. So, like many other Chinese with offshore holdings, Liu decided to bring her money back home. She sold some U.S. stocks and made a downpayment on a $160,000 apartment in Shanghai's tony Jingan district. "I'd rather have my money in property," says Liu. "Besides, if the yuan is going to be revalued at six to a dollar, you've just made money."

Rational behavior, perhaps. But worrying, as well, for Beijing's financial mandarins. By rushing to swap their dollars for yuan, Chinese investors and savers are demonstrating that the mounting calls in the U.S., Europe, and Japan for Beijing to revalue its currency already are starting to influence financial markets -- even though China insists it will maintain the peg. More ominously, as citizens such as Liu -- as well as overseas Chinese from Taiwan to Toronto -- plow those funds into mainland assets, there are fears the overvalued yuan could fuel a nasty bubble. In Shanghai, prices for luxury flats have risen 62% since 1999, to around $1,400 per square meter.

The quandary is what China should do to stem a bubble. Critics of China's currency regime say the speculation bolsters their argument the yuan should float, or at least be sharply revalued. China is indeed bulging with dollars: Its foreign reserves stand at a stunning $346 billion and are rising fast, fed by export earnings, foreign investment, and the return of $20 to $30 billion in the past six months in funds held offshore or under mattresses, says J.P. Morgan Chase & Co. economist Joan Zheng. Such imbalances could ignite the kind of frenzy and overbuilding of everything from office towers to steel mills that preceded Asia's 1997 crisis.

But boosting the value of the yuan may not be the best way to tame China's capital flows, say a growing number of economists and currency analysts. In fact, it could do more harm than good -- not just for China but also for the global economy. Among the hazards on the Chinese side: a big slowdown in the mainland's export machine. That would depress China's need for imported raw materials and machinery. It also would hurt incomes, which would lower Chinese demand for imported consumer goods. On the U.S. side, a higher yuan would boost U.S. prices for everything from toys to power tools, and trigger a fall-off in Chinese purchases of U.S. Treasury securities.

The more fundamental risk is that breaking the yuan peg would shatter faith in China's currency stability, with big consequences for the mainland economy. Stanford University economist Ronald I. McKinnon argues China's dollar overhang is so huge that dollar-selling in China might feed on itself. Beijing might have to revalue upwards not just once, but several times -- with dire results for exports and eventually domestic demand and prices. "Once people get the idea the yuan will always be higher next year, you get intense deflationary pressure," McKinnon says. "This is exactly what happened to Japan 10 or 15 years ago," when Tokyo strengthened the yen at U.S. urging.

If Beijing gets its currency policy wrong, it could derail one of today's only big economic growth engines -- one that is sucking in immense quantities of car parts, computer chips, and machinery. The money China recycles into the U.S. by buying $10 billion in Treasury bonds each month, meanwhile, is vital to keeping down interest rates and financing America's yawning current-account and federal budget deficits, which are nearing a combined $1 trillion. With saving rates dropping in Japan, Korea, and Taiwan, China is emerging as an even more vital exporter of capital.

Is there a way out of this fix? Economists say that instead of revaluing, Beijing could stop subsidizing export industries. It also could let foreign companies in China borrow yuan rather than bring in dollars. And it could allow Chinese citizens and financial institutions to buy foreign stocks. Besides reserves held by the central bank, Chinese businesses and households -- which sock away 28% of annual income -- have amassed $150 billion in dollar accounts in local banks.

Whatever it does, Beijing must keep China's economy moving. Chen Zhao, chief emerging-market strategist at Montreal-based Bank Credit Analyst Research Group, notes that China is emerging from eight years of dropping consumer prices caused by oversupplies of everything from farm goods to TVs. Thanks to rising incomes due in part to the export boom, demand is picking up. But inflation is a meager 0.3% despite lots of fiscal stimulus from Beijing. And while Shanghai housing prices are surging, China's overall property market still hasn't recovered from a bust a decade ago. "A little heat is good right now for China's economy, and the rest of the world should be encouraging it," Chen contends. If the yuan rose 15%, he predicts Chinese deflation will return.

Slower Chinese demand also could hammer world trade. Even though China's politically sensitive trade surplus with the U.S. is rising, China's overall trade surplus has shrunk 70% in six months, to $6.9 billion. That's because imports have surged by 45% in the past year, to $350 billion, and are rising faster than exports. That may seem counterintuitive, since a cheap currency makes imports more expensive. But as China dismantles trade barriers, demand for luxury cars and cell phones is soaring. And to fuel its export machine, China must import electrical components, raw materials, and oil. China's steel imports soared 80% in the first seven months of this year, to 30 million tons. And China's imports of machinery leaped 50%.

Beijing leaders can't ignore signs of overheating, of course. In Shanghai, stories abound of Taiwanese investors buying luxury flats and flipping them at a 15% profit in one week. Real estate is seen as a "one-way bet," says Christopher Cuff, executive director for agency services at Cushman & Wakefield Premas. "Property has to go up, and there's a significant chance the yuan will appreciate." In June, the central bank said it would tighten credit for developers and homebuyers.

Beijing is already trying to soak up excess liquidity. Since late 2002, commercial banks have repatriated $60 billion from the U.S., Morgan Stanley estimates. To head off a lending binge, the government is issuing bonds. But the money supply is still growing at 20%, and China lacks a developed market for trading such paper. Beijing also is mulling a cut in tax rebates for exporters. There's even talk of letting Chinese mutual funds and insurance companies buy Hong Kong stocks, and of making it easier for Chinese companies to make foreign acquisitions.

Expect more shrill cries from Washington for China to revalue the yuan. But Beijing may do well to demur. It could do the global economy a bigger favor by finding a way to ease its dollar glut without choking demand.

By Frederik Balfour in Hong Kong, with Alysha Webb in Shanghai, and Peter Coy and Pete Engardio in New York

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