Jubak's Journal
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No more China on the cheap
The worlds most populous country has taken a tiny step toward letting its currency fight it out on the world stage. That could have huge consequences for what a dollar will buy.
By Jim Jubak
Hardly dramatic, was it? After months of speculation and political posturing from Washington and Beijing, China finally revalued its currency, the yuan, by a whopping -- hold onto your hats -- 2.1%. Yep, the currency, which traded at 8.28 yuan to the dollar on July 20, appreciated to 8.11 to the dollar on July 21. That's well short of the 20% or so revaluation of the Chinese currency that most economists think is required to make a significant dent in the U.S. trade deficit with China.
But in the long run, this move, tiny as it seems, will have immense consequences for the value of the dollar around the world; for the prices that U.S. consumers pay for Chinese exports; for the prices of commodities such as iron, oil, soybeans and corn; and for the Chinese economy and the country's struggling stock market.
Here's how tiny revaluations grow into mighty trends.
China did more than just revalue its currency by 2.1% on July 21. Before the revaluation, the value of the yuan was pegged to the U.S. dollar and the Chinese central bank worked hard to keep the two currencies in line within a relatively narrow band. After the revaluation, the value of the yuan will be linked to the value of a basket of currencies and allowed to rise or fall up to 0.3% against the U.S. dollar on any single day. This kind of currency system, successfully practiced by Singapore for decades, is called a managed float, since the Chinese central bank will intervene to make sure than the yuan doesn't rise or fall more than 0.3% on any day. The Chinese are keeping mum about the exact composition of that basket of currencies, but the informed guessing is that it includes the euro and the Japanese yen, along with the dollar.
Selling dollars
Since we don't know the exact composition of that basket, we can only guess at the size of the effect on the dollar. But we do know that switching from a dollar peg to a managed-basket float will put downward pressure on the dollar. To manage the yuan's value against a basket of currencies, the Chinese central bank will need to move some of its dollar reserves into other currencies. That will involve selling dollars and buying euros, yen and whatever else is in the basket. Even if the selling is relatively minor, the bank will certainly cut back on the rate at which it accumulates new dollar deposits. That's one less buyer in a world where the U.S. trade deficit constantly supplies the currency markets with more dollars.
Of course, the change in Chinese policy could mean that other countries cut back on their dollar-buying, too. At the least, the Chinese move will encourage the move toward diversification that the central banks of Korea, Taiwan and Japan were tentatively exploring even before July 21. If the Chinese are moving some of their reserves from dollars to euros and yen, you can bet that the Koreans, Taiwanese and Japanese will follow.
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And while it's likely that none of China's Asian competitors will want their currencies to rise against the yuan or to make a big move higher against the dollar, a gradually appreciating yuan would lessen the need of countries such as Taiwan, Korea, Malaysia, Japan and Thailand to intervene in the market by buying dollars to keep their currencies from appreciating against the U.S. currency. Already, Malaysia has followed China's lead to moving its currency, the ringgit, from a strict dollar peg to a managed float against a basket of currencies. All in all, there will be less dollar buying, even though we don't know how much.
Just how high?
A lot depends on how hard the yuan presses up against that 0.3% daily ceiling. Futures markets are betting that the daily pressure will add up to sizable appreciation in the yuan over the next year. The day after the revaluation, for example, contracts for hedging against the yuan were priced for a further 6% appreciation in the Chinese currency by the middle of 2006. Other currency experts are predicting a 5% strengthening in the yuan by the end of 2005. The most bullish projections that I've seen call for the yuan to gain 7% by year end and 15% by the end of 2006. Reports that the Chinese central bank was overruled as it pushed for a more aggressive 5% revaluation just fuel this speculation.
That speculation wouldn't be important, except that in currency markets speculation is a self-fulfilling prophecy. As more and more hot money bets on a further appreciation of the yuan, it becomes more and more difficult, and expensive, for the Chinese central bank to prevent the yuan's appreciation. China may have massive foreign currency reserves but its resources are dwarfed by those controlled by currency traders with their ability to leverage their own considerable currency assets.
But you don't have to believe that the speculators will win to believe that the yuan is headed higher from here. There's good reason to think that the Chinese would like to see a gradually stronger yuan. The Chinese, you see, are trying to make their stock exchanges into real financial markets and sources of capital for Chinese companies. As part of that, the government has decided to make all the currently nontradable shares of public Chinese companies tradable. In effect, that would flood the stock market with shares that are currently held by state-owned companies. Currently about two-thirds of shares by market value can't be traded.
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