Wall St. and Business Wednesdays: E-Letter To Steve H. Hanke and Forbes Re: "Beijing’s Tactical Retreat"

I thought of your excellent new article in Forbes magazine, "Beijing’s Tactical Retreat," yesterday, as I read the news that Chinese exports have risen despite the revaluation of the Chinese currency, the yuan. As you note in your piece, it was a tactical move on the part of China, on July 21, 2005, to finally appear to capitulate to Bush administration and Congressional demands, spurred by a domestic protectionist trade lobby, to make the yuan more valuable in terms of the dollar. The yuan was allowed to move from 8.28 to the dollar to 8.11, a 2.1% yuan appreciation. The United States government applauded the move as a first step toward reducing the trade deficit between America and China and as a way to allow China, in the words of Secretary Snow, to "more easily and effectively pursue price stability, stabilize growth and respond to economic shocks."

As yesterday’s numbers prove, the move did little if anything to make China’s exports less desirable to America, by making them more expensive. As you wrote, the entire rationale, advanced by the U.S. is "laughable." First, a 2.1% appreciation of the yuan is not enough to make U.S. goods more competitive against those produced by the Chinese economy. It is actually almost sad to see American trade officials and interest groups make the same pitiful export-driven recovery arguments made by the IMF when it demands that 'developing' nations devalue their currencies in order to reduce imports and increase exports. The United States position essentially amounts to that as it is really seeking a relative devaluation of the dollar, in its revaluation of the yuan. The U.S. demand for Chinese goods - 14% of all U.S. imports come from China - is almost insatiable at this point, and for all of the complaints offered by U.S. textile interests and others, who say they are hurt by a weaker yuan there are U.S. retailers, like Wal-Mart and Home Depot and electronic manufacturer Motorola who are enormously dependent upon Chinese goods and do not desire a stronger Chinese currency. So not only is a 2.1% increase in the value of the yuan not going to curb their appetite, but these large multi-nationals actually have the ability to pass along their increased import costs, caused by an increased yuan, on to their suppliers. In addition, the American "revalue the yuan" advocates are only thinking in terms of one variable – Chinese exports. It is obvious they have not thought through the effects a revaluation will have on Chinese imports. While the country’s exports increase, its imports have grown far more slowly, as a result of higher oil prices and the nation’s own domestic economic policies – including price controls that serve as a disincentive to invest and produce. I actually think the yuan revaluation, from the Chinese perspective was aimed as much at helping the country better afford oil purchases than it was to satisfy or placate American interests in slowing China’s export growth.

Next, United States officials are being disingenuous when they argue the revaluation will allow China to "more easily and effectively pursue price stability, stabilize growth and respond to economic shocks." As you note, they already have price stability and growth, writing, "It is not as if China has been making a mess of its economy. Since the yuan's fix to the dollar in 1995, China's real growth rate has been second to none, exceeding 8% per year on average. It also passed the Asian financial crisis shock test with flying colors. Real growth was 6% in 1998, the year after the Thai baht collapsed and set off a wave of Asian recessions, and 6.2% in 1999. And all this growth has been accompanied by tame inflation--an average annual rate of 2.25%, less than the U.S. rate."

As you write, and whether it is intentional or not, if China were to follow the advice of some in the United States – to revalue its currency by 20%, making the exchange rate close to 6 yuan to 1 dollar it would absolutely ruin the economy. Your estimation that, "an appreciation in the yuan of 20%--a number tossed around by many Washington politicos--would generate a 16% deflationary impulse. This would completely sink China's banking system and spread untold hardship among China's 800 million restless rural residents," is correct, and Beijing would be foolish to follow such a suicidal path. Your analogy between the poor and selfish advice America is giving China today and that which it gave them regarding silver in the 1930s is brilliant and appropriately makes the case for China against following a U.S. guided deflation.

It is actually the United States, rather than China which has placed itself in this vulnerable position, where it has to plead and beg another nation to manipulate its currency, against its own long-term interests. When the dollar went off of the gold standard, in August of 1971, the United States effectively abdicated its responsibility as the ‘world’s currency’, the center of the monetary universe - the most sound, stable and reliable around which all other currencies could effectively revolve. Since then world exchange rates have been in chaos, a mess that could easily be resolved if the right nation or groups of nations would return to a fixed exchange regime, my favorite - a currency defined in terms of gold.

I actually think that in this regard, it is possible that the China revaluation - which the late Jude Wanniski wrote would benefit China's economy - is a step in the right direction. The United States believes that the decision to have China manage the value of its currency according to a secret basket of currencies – as is the Singapore dollar currently – is a step toward China one day soon allowing its currency’s value to float freely in world currency markets. They are deluding themselves. China’s managed peg - and all of the flaws that accompany it - is a transition step, I believe, not toward a floating currency but toward a fixed currency regime, even an Asian monetary bloc, perhaps one day backed by gold.

Interestingly, Malaysia, the country that has been most vocal in calling for an Asian or Islamic gold standard, immediately indicated it would follow China in revaluing its currency, the ringgit. If other Asian economies follow suit, it would not only indicate the region might be moving closer to a monetary union, but it also shows they have learned the lessons of the currency crisis they endured in the late 1990s - the so-called Asian flu. Instead of a round of competitive currency devaluations, we may be poised to some day soon see a round of competitive revaluations, with the currencies of Asia orbiting around China and not the United States.

The key relationship to watch, to me, is that of China and Japan. China has now surpassed America as Japan's largest trading partner, with $200 billion in trade (representing 20% of Japan's total trade). In addition, China is the second-largest holder of U.S. Treasury securities with $243.5 billion of U.S. government securities as of May 2005. Japan is the first. And only Japan has more foreign exchange reserves than China’s $711 billion as of June. If China exchanges its holdings of U.S. Treasury securities (a move that could bring down the U.S. housing market) or dollar holdings for a basket of Asian currencies or gold; or if Japan and China can accelerate discussions around an Asian monetary union, it may be Washington D.C. that makes a tactical retreat rather than Beijing.

Time will tell.

I look forward to reading more of your insight.

Cedric Muhammad

Wednesday, September 14, 2005