A Slow Boat to Yuan Devaluation

With a too-hot economy, China knows it has to change its fixed currency system. But all options are risky, hence Beijing's foot-dragging

By Brian Bremner

"Soon," "someday," "drop dead" -- such are the responses from Beijing officialdom when asked for the umpteenth time about when China will overhaul its fixed currency regime. One hopeful remark electrifies the currency markets momentarily, only to be contradicted days later.

Why all the blasted noise? Well, truth is there are deep divisions within Chinese President Hu Jintao's government about the wisdom, timing, and sequencing of any moves away from the yuan's peg of 8.27 to the U.S. dollar. If nothing is done, China's massive trade surpluses will swell further, and Beijing will get blasted for naked mercantilism. A massive economic bubble is another risk. But if China moves too fast to liberalize, it will court a financial system crash, widespread joblessness, and maybe social unrest.


  China has no easy ways out of this dilemma. It's probably a decade away from a real free-floating yuan and full-blown capital liberalization. Some 90% of the country's $1 trillion-plus in savings sits in bank deposits, while credit agency Standard & Poor's (like BusinessWeek and BusinessWeek Online, a division of The McGraw-Hill Companies MHP ) figures 35% of all Chinese bank loans -- some $600 billion -- are in default. Imagine the chaos if Chinese savers shifted a chunk of their wealth offshore. China's banks would collapse left and right.

A more realistic option being explored by Beijing would be a two-stage program that involves a widening of the yuan trading band to 5% or so, from about 1% now, and the adoption of a multicurrency basket involving the dollar, yen, euro, and key Asian currencies such as the Korean won.

Nicholas R. Lardy, a China finance watcher and fellow at the Institute for International Economics in Washington, D.C., believes monetary bigwigs, such as People's Bank of China Governor Zhou Xiaochuan and his central bank economists, decided in early 2003 when the economy really started overheating that such a shift could be put off no more. The task now -- and it's a big one -- is to get approval from the highest echelons of government, says Lardy. That means Hu and Premier Wen Jiabao, plus other Politburo heavies.


  China's economy is still white-hot. It grew an astounding 9.5% in 2004, far higher than expected, though inflation cooled compared to 2003 levels, as did government-driven fixed investment.

There's no obvious signs of a bold shift, at least based on the rhetoric. At the World Economic Forum in Davos, Switzerland, last month, Chinese Vice-Premier Huang Ju said while flexible exchange rates were coming, the government would gradually press ahead with this.

If China does opt for slow action, as most experts expect it to, shifting to a wider band and currency basket might do the trick. That would be just enough to quell critics abroad, but not enough to derail its export growth. First off, a 5% or even 10% appreciation of the yuan wouldn't have much impact on China's trade surplus with the U.S., which hit an estimated $150 billion last year, up 20% over 2003. While estimates on the yuan's undervaluation vary, most experts think the figure is at least 20%.


  Also, adopting a basket of currencies would hardly cost China much in trade competitiveness. It likely would create a basket that would include the dollar, yen, and euro, each weighted at about 30%. Each component of the basket would trade or, in market jargon, "crawl" vs. the yuan.

The most likely scenario is that the yuan would appreciate against the dollar -- but hold steady or even depreciate against the other currencies. Under this scenario, odds are Chinese products would remain extremely competitive worldwide.

However, another problem would still bedevil China, regardless of what it does: the massive amount of capital flowing into the country. A peg can be costly to defend, especially with China's draconian capital controls. Last year, the People's Bank of China had to sell yuan and buy dollars to recycle some $32 billion worth of export earnings, $65 billion worth of foreign direct investments, and a staggering $100 billion worth of speculative inflows into China in the form of real estate deals and other investments, figures S&P analyst Ping Chew.


  Much of that extra yuan ended up in the country's broad money supply -- which grew by 20% in 2003 and an estimated 16.2% last year -- and the nation's banking system -- where a good bit of that fueled the investment boom.

All of this works against efforts to get China on a slower, sustainable growth track. More sedate growth is necessary to avoid the kind of boom and bust cycles that are devastating for a developing economy like China's, which needs to absorb 10 million new workers a year. Some economists think the country grew 10%-plus, instead of the less scary official figure of 9.5%.

Beijing confronts some very tough trade-offs. So it's no wonder it has met the challenge so far with studied inaction.

Bremner is Asia regional manager for BusinessWeek based in Hong Kong

Edited by Patricia O'Connell

Before it's here, it's on the Bloomberg Terminal.