A Higher Yuan: When, Not If
By David Cohen
While financial markets spent the past few weeks with their attention focused elsewhere, the "elephant in the room" for world trade -- the substantial global financial imbalances surrounding China's currency -- once again made its presence felt. Most recently, China reported that its foreign-exchange reserves soared to $609.9 billion in December, from $514.5 billion in September.
This $95.4 billion jump brought the total increase for 2004 to $206.7 billion. And all the while, Chinese authorities continue to intervene in currency markets to maintain the currency peg of the Chinese yuan to the U.S. dollar. That peg keeps the yuan's value fixed against the greenback, and has been the bete noire of U.S. manufacturers, who assert that the yuan's artificially low level gives Beijing an unfair advantage in global export markets.
"IN CHINA'S HANDS."
Indeed, the fourth-quarter increase in China's foreign-exchange reserves represented an acceleration from the $43.9 billion rise in the third quarter, underscoring a widening balance of payments surplus that will likely heighten pressure on Beijing to permit some flexibility in its exchange rate. This is because the Chinese authorities are under increasing pressure to purchase U.S. Treasury securities to preserve the peg, and these accelerating purchases appear increasingly unsustainable. And it doesn't help that this acceleration in official purchases is occurring alongside what appears to be a heightened pace of trade-deficit deterioration in the U.S. (see BW Online, 1/13/05, "A Rising Trade Gap Sinks Growth").
Right now, the markets expect some movement in the direction of greater exchange rate flexibility sometime this year. China has given hints to that effect, but has avoided giving any timetable. We at Action Economics believe China will move to allow the yuan to fluctuate in a band vs. the U.S. dollar -- of perhaps plus- or minus-5% -- sometime within the next six months.
International trading partners remain leery of publicly urging Beijing to ease up on the peg, as they are understandably concerned that it might backfire in the face of the Middle Kingdom seeking to avoid appearances of caving into foreign pressure. That did not hold back European Central Bank chief economist Otmar Issing, however, who made headlines Jan. 11 with his grumbling that Europe was carrying too much of the burden of recent foreign-exchange adjustments, and that Asia must do its share. Though the biggest immediate market reaction came in a strengthening of the Japanese yen, Issing emphasized that the key was "above all in China's hands."
HUGE AND GROWING.
Europe's complaints arise from strength in the euro -- up over 8% against the greenback since the middle of last year -- which has been blamed for crimping the recovery in the 12-nation euro zone. Issing's remarks were seen as perhaps a prelude to the two-day meeting of finance ministers from the Group of Seven industrial powers set to commence in London on Feb. 4. A Chinese delegation will attend that meeting in a similar capacity as at the G-7 meeting last October.
The substantial Chinese balance-of-payments surplus is one element of the major global imbalance in which the U.S. current-account deficit also figures prominently. Few believe that the U.S. deficit, at over 5% of GDP last year, is sustainable. Perceptions are that it must be addressed, in part by U.S. moves to trim its fiscal deficit. But even then, at least part of the solution must also come in the form of further exchange-rate adjustment.
The November U.S. trade deficit highlights the urgency of the problems underlying the current global imbalance, as the U.S. trade deficit is still setting record highs, and doing so at what some fear is an accelerating rate. By David Cohen
BETTING ON THE YUAN.
Meanwhile, the Chinese export juggernaut shows no signs of slowing. China recently reported December trade data showing export growth remaining robust, rising 32.7% year-over-year, and up 4.7% from the previous month (on a nonseasonally adjusted basis) to a new high. Imports grew by 24.6% year-over-year, and these figures also set a new record.
This translated into a bounce in the Chinese total trade surplus to a record $11.1 billion, or nearly double the level of a year ago. The figure represents an eighth consecutive surplus after four consecutive monthly deficits. For all of 2004, exports rose 35.4%, while imports grew 35.9%, for an annual trade surplus of $32.0 billion. That was up substantially from the $25.5 billion reported for 2003.
This trade surplus constitutes a moderate annual total, one that is dwarfed, for example, by Japan's overall trade surplus of more than $100 billion in 2004. But the swing back to a widening surplus in recent months, after a cumulative deficit through August, 2004, might make it more difficult for the government to deflect international pressure to revalue the yuan peg.
The bulk of China's balance-of-payments surplus of over $100 billion comes from capital inflows. This includes foreign direct investment totaling $57.6 billion through the first 11 months in 2004, alongside heightened speculative inflows in anticipation of potential yuan appreciation.
Pressure on China is intensified by the much larger bilateral trade surplus with the U.S., which U.S. data showed at a $124 billion deficit in 2003, and a likely $162 billion for 2004, given data through November. This is wider than the overall annual trade surplus of $32 billion that China reported for 2004, highlighting how the Middle Kingdom runs a net deficit with the rest of the world, other than the U.S.
In part, this reflects certain intermediate imports by China from elsewhere in Asia and assembled for export to the U.S. Thus, the massive bilateral U.S. trade deficit with China could be viewed, in part, as a proxy for the U.S. deficit with the entire region.
In this sense, a move by China to permit currency appreciation against the dollar might open the door for a broader move by Asian exporting nations to allow their currencies to appreciate as well. Many have resisted appreciation of their currencies for fear of losing competitiveness to China, a very real threat.
This is reflected not only in other currencies pegged to the U.S. dollar, such as those of Malaysia and Hong Kong, but also in the substantial foreign-exchange intervention by authorities across the region. After record purchases of the dollar during several quarters through the first quarter of last year, intervention subsided during mid-2004 as the dollar firmed. But there has seen a renewed surge in foreign-exchange reserve accumulation by these nations since September, as the dollar again came under pressure.
Can this trend last? At some point, not only admonishment from the U.S. and Europeans, but worries over the prudence of continued massive accumulation of U.S. Treasury securities, might prompt these nations to tolerate further appreciation of their currencies against the greenback. But ultimately, the first step must come from China. And amid pressure from trading partners and others to alter its currency stance, it's likely the Middle Kingdom will chart its own course as to when -- and by how much -- it will bend.
Cohen is director of Asian economic forecasting for Action Economics