Henry Paulson's Holiday Wish List

The U.S. Treasury Secretary will be asking Beijing for faster appreciation of the yuan and reforms that will let foreigners in on China's investment banking boom

As he packs his bags for the third China-U.S. Strategic Economic Dialogue starting Dec. 12 in Beijing, U.S. Treasury Secretary Henry Paulson has made no secret of the things he wants for Christmas from the Chinese. Topping this season's wish list is his desire to see the yuan gain strength more quickly against the U.S. dollar, as well as further liberalization of capital flows. He'd also like to see an increase in structural reforms, particularly to give foreign banks greater participation in China's booming investment banking business.

His visit comes against the backdrop of a yawning U.S. trade deficit with China. During the first nine months of the year, it was $187.6 billion, and 2007 is on track to exceed 2006's $232.5 billion. Although the yuan has gained about 5.5% against the greenback this year, this has had little impact on American demand for such Chinese-made items as dining room tables, flat-screen TVs, and garden gnomes.

Pressure against China has been steadily building in Congress where Democrats have been advancing measures against China if Beijing fails to make more concrete attempts to narrow its trade surplus. Regardless of whether these bills see the light of day, the Chinese have expressed concern over what they perceive as a confrontational strategy. "We should avoid unreasonably and unilaterally blaming the other side," newly appointed Commerce Vice-Minister Chen Deming said in an interview with the official English-language mouthpiece China Daily, published on Dec. 10. He also urged the U.S. not to "politicize" trade frictions and disputes.

Struggling With Its Own Problems

Still, it's highly unlikely that China will give in to pressure on its exchange rate, which is carefully managed by the central bank, the People's Bank of China. The bank pegs the value of the yuan to the dollar each morning, allowing deviations of no more than 0.5% on either side of the official rate. However, Chinese Premier Wen Jiabao told an EU-China Business Summit on Nov. 26 that Beijing would improve the exchange-rate regime "in a proactive, manageable, and gradual manner," with a view toward gradually enabling capital-account convertibility.

Meanwhile, China has been struggling with its own macroeconomic problems created by its undervalued currency. Every dollar of trade surplus that China racks up is potentially another dollar injected into its money supply, unless the central bank is able to mop up the additional liquidity by selling bonds or increasing the amount of money that banks must keep with it in reserves.

On Dec. 8, Beijing said it would hike the amount of reserves commercial banks must keep with the People's Bank of China from the current level of 13.5% to 14.5%, effective Dec. 25. The increase, the 10th so far this year, "reflects the urgency of inflation concerns of the government," Goldman Sachs (GS) China economist Hong Liang said in a note to clients.

Government Unable to Rein in Money Supply

China is scheduled to release November consumer price index figures on Dec. 13, with economists expecting the number to top the October year-over-year inflation of 6.5% because of higher fuel and food prices. Jing Ulrich, chairman of China equities at JPMorgan (JPM), says that Chinese inflation is "structural, not just a passing phenomenon." Although she reckons Beijing will resort to moderate interest-rate hikes next year, she expects the government will continue to depend heavily on administrative measures to rein in the economy, which is galloping along at about 11%.

Stephen Green, Shanghai-based economist for Standard Chartered Bank, points out the government is virtually unable to tighten the money supply to cool demand. "They are really stuck up the inflationary river without a monetary paddle," he said. That's because if China increases its interest rates while the U.S. Federal Reserve leaves its rates unchanged or even lowers them, more capital will flow to China, thereby increasing the money supply instead of tightening it.

Although no one expects a breakthrough at this week's economic confab between Paulson and Vice-Premier Wu Yi, that doesn't mean the former Goldman Sachs banker will come home empty-handed. China announced on Dec. 9 that it had given the green light on a long-awaited decision to increase quotas on foreign institutions investing in China's domestic stock markets from the existing $10 billion to $30 billion.

China also could announce that it will approve two new foreign joint ventures in the securities industry. Credit Suisse (CS) last week signed a memorandum of understanding with Beijing-based China Founder Securities, which suggests a license is forthcoming before the end of the year, said a person familiar with the negotiations. Morgan Stanley (MS) is also expected to receive a license to set up a joint venture with underwriting privileges with Shanghai-based China Fortune Securities. Morgan Stanley declined to comment.

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