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What's ahead as China revalues the yuan
By Tony Crescenzi 7/28/2005
China's revaluation of its currency, the yuan, has varied implications. Here I'll present several of them along with other key points and facts and figures on the issue.
The Treasury market's initial reaction was overdone, as China's monthly purchases of Treasurys are not likely to change much anytime soon. The revalue isn't likely to result in more than $1 billion in monthly impact at most, and this is a stretch. With Treasurys trading nearly $600 billion per day, such a sum would be a drop in the bucket.
The $1 billion maximum forecast is derived by considering that China has been purchasing about $2.3 billion of coupon Treasurys monthly over the past year, in addition to about $1.8 billion of T-bills. Thus, China's total monthly purchases of Treasurys have averaged about $4 billion per month. It seems unlikely that the modest yuan revaluation would alter the monthly tally by more than several hundred million dollars per month.
Moreover, even with full flexibility, China is likely to continue to accumulate Treasurys, just as Japan has been a large buyer for many years despite having a fully flexible foreign exchange system. The main reason is because China, like Japan, earns large amounts of dollar reserves on a daily basis. Many of these dollars will flow back into the Treasury market.
What it means for inflation
The impact on inflation will be minimal. For each 1% rally in the yuan, import prices will rise by about 0.14%, given that China accounts for about 14% of all U.S. imports. The impact is actually likely to be smaller than that, assuming substitution effects and the fact that some of the U.S.-China trade is being conducted in dollars. A 10% revalue would thus boost import prices by about 1.4%. The impact on U.S. consumer prices would be diminished by the fact that the $215 billion in annual imports from China are a very small part of the $12 trillion U.S. economy. It would thus take a 5% revaluation of the yuan to move the consumer price index 0.1%, again assuming no substitution effects (unlikely) and the false assumption that all of the trade between the U.S. and China is transacted in yuan.
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For those who worry that China will sell some of its Treasury holdings when it begins to diversify its reserve assets, it should be noted that Japan, which holds $685 billion of Treasurys, has been diversifying its reserve assets since August and has hence been a net seller of Treasurys, yet interest rates have nonetheless fallen for the most part since then. In the same way, if China were to diversify its assets, the impact would likewise be minimal and readily absorbed, especially with the U.S. budget deficit on the way down, which is freeing up tens of billions of investment dollars.
China's impact on the U.S. fixed-income market extends beyond Treasurys. Over the past year, China bought about $19 billion of U.S. corporate bonds and $17.2 billion of agency securities. Here too, however, the sums are too small to impact the main dynamics shaping these markets. Nevertheless, to the extent that the corporate and agency markets are smaller markets than the U.S. Treasury market, the impact could be greater, albeit small.
The rest of the story
There is a secular story here related to labor costs and inflation that may be bearish for the bond market but which will take many years to play out. China's revaluation symbolizes its emergence as an economic power and its increased status, and this should benefit Chinese households by boosting incomes there. As China's labor costs rise, the disinflationary effects from China that have helped keep global inflation low over recent years will wane, thus boosting inflation. Nevertheless, with labor costs at roughly 30 cents per hour in much of China, it will be many years before Chinese labor costs are high enough to provide much of an upward thrust to global inflation. | Yuan Revaluation | The impact of China's yuan revaluation will be felt far and wide.
China is likely to keep accumulating U.S. Treasurys because it earns large amounts of dollar reserves on a daily basis.
China is unlikely to move toward a fully-flexible exchange rate for at least several years. |
Future moves toward flexibility of the yuan are likely to coincide with China's economic news. It is no coincidence, for example, that China announced its revaluation just a few days after it reported strong GDP data. The timing of the announcement was likely a signal about what would likely be a catalyst to future revaluations. China's fixed-exchange-rate regime has been a source of economic strength because it has invited the inflow of foreign capital. It's akin to eBay (EBAY, news, msgs) keeping its stock price at $80 while its value has actually increased to $300+. If such a situation existed, investors would pour money into eBay, recognizing the cheapness of its shares. Similarly, the fixed regime in China has made China a cheap investment, and money has poured in. This creates the risk of imbalances such as excess capacity, something that revaluations will help to avoid.
China likely wants to keep its currency somewhat overvalued to allow for a cushion against weakness when economic growth eventually slows and hence the veritable exit from one door commences.
China is unlikely to move toward a fully-flexible exchange rate for at least several years, as China will want to protect its economic gains via the relative stability of the U.S. dollar. China is already hinting as much, judging by comments that Li Deshui, a member of the Bank of China's monetary committee, delivered in an interview with Bloomberg. He said it would be at least five years before China moved toward full convertibility of the yuan because if it were done sooner, there would be a risk of speculation against the currency, as was seen against the Korean won and the Thai baht in 1997. Such speculation would be possible if China's economic growth was to slow and its banking sector's woes were hence put under greater scrutiny.
The speed of future yuan revaluations will be dictated in part by the actions of the Federal Reserve and the impact that the Fed's actions have on the value of the U.S. dollar. For example, if the Fed were to cut interest rates, hence creating a downward tendency for the dollar, the Chinese might speed the pace of future revaluations, as it would fit naturally with the fact that other currencies are rising faster against the dollar, too. Conversely, when the Fed raises interest rates and the dollar rallies, the Chinese are likely to slow the pace of revaluation, as it would fit with the fact that the dollar is rising in value against other currencies.
Tony Crescenzi is the chief bond market strategist at Miller Tabak + Co., LLC, and advises many of the nation's top institutional investors on issues related to the bond market, the economy and other macro-related issues. At the request of the Federal Reserve, Crescenzi is a regular participant in the board's Livingston Survey of economic forecasters. He is also the author of "The Strategic Bond Investor." At the time of publication, Crescenzi or Miller Tabak had no positions in the securities mentioned in this column, although holdings can change at any time. Under no circumstances does the information in this column represent a recommendation to buy or sell stocks. Crescenzi also is the founder of Bondtalk.com, a popular Web site covering the bond market and the economy.
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