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China Needs a Stronger Yuan

By Michael Cheah and Sean Daly

China’s foreign currency reserves topped $3 trillion this year, with a $197 billion rise in the first quarter alone.  With the June increase in the consumer price index expected to clock in at 6 percent—surpassing a 34-month high set in May—it is clear that China’s monetary situation is now approaching an important new inflection point.

In this new context, a stronger yuan is now in China’s interest.  Interest rate hikes and the price controls are ultimately only tactical. What China needs is the great sweep and clarity that only currency appreciation can bring—not only to defuse inflation but to set future business growth on a more promising track. 

For nearly two decades, Beijing’s managed-currency policy has been stunningly successful.  By keeping the value of the yuan (RMB) artificially low, China promoted an export-driven economy that spurred investment, job growth, and genuine quality of life for large swaths of its population.  

Beijing now faces a new set of challenges. Handled properly, this new period of modernization could take China up the ladder of “value-added manufacturing,” innovation, and global services.  But getting there will require certain policy adjustments.  First, in order to avoid the mistakes of Japan, China must re-circuit its economy for domestic growth and more service sector expansion.  Second, it must step beyond the lessons learned in the 1997 currency crisis—lessons that were essential for nearly a decade but that are less useful today. 

As China’s economy grew rapidly in the past two decades, enormous capital inflows could have driven up the price of the yuan sharply, as foreign investors bought yuan and sold U.S. dollars. However, to prevent a stronger yuan from making their exporters less competitive, the People's Bank of China (PBOC) consistently intervenes in the market to sell yuan and buy U.S. dollars. All these dollar purchases have now turned into a $3 trillion investment challenge. More importantly, PBOC's sales of yuan are, in effect, like “printing money”—an effect magnified when this “new money” is loaned out by banks.

As a result of these policies, money supply has grown 50 percent since 2009, creating inflationary pressure. Home prices in many coastal cities have doubled. Food prices alone rose nearly 12 percent last year.  And due to a severe drought, the cost of traditional staples has soared further in May, with the price of one type of fish surging by 22.5 percent in one month.

In addition, China is losing billions a month on its FX intervention. Its sizable foreign currency reserve is now a source of vulnerability, not strength. With $3 trillion bought at an average price of 7.5 RMB per dollar, what happens when the exchange rate moves to 5 RMB per dollar? 

Another negative effect of FX intervention is that the practice actively suppressesthe purchasing power of the average Chinese consumer, and thus the future prospects for growth. Keeping the yuan artificially low against the dollar has propped up China’s export sector, by making goods manufactured in China cheap for consumers in the U.S. and the rest of the developed world. But China needs to shift away from relying on exports in order for its economy to develop beyond its manufacturing sector, toward a service sector economy that can compete with more advanced countries.

Though it may sound counter-intuitive, a RMB appreciation will speed a necessary transition to better jobs. It will hasten the shift of manufacturing inland, to cities like Chongqing, where labor is still quite cheap and industry can leverage that benefit in lieu of the modest drop in currency competitiveness. 

Coastal exporters are quick to suggest that thousands will go jobless if the yuan appreciates. But coastal factories are paying high wages for workers now and the big companies are already making this transition. 

As MIT’s Yasheng Huang recently quipped in a recent New York Times article:  “Any ‘labor shortage’ in Guangdong is mostly evidence that the factories should not be located there in the first place.”

The benefits of moving manufacturing will be threefold and will feed into one another in a positive feedback loop:

  1. With cheaper inland wages, industry becomes less reliant on FX policy.

  2. Despite lower wages, workers will enjoy a higher quality of life and better housing.  This will spur domestic demand and encourage what economists refer to as “household formation”— people marrying, buying houses, and spending money on big ticket items like automobiles and washing machines.

  3. Beijing will achieve its objective of balanced growth and so-called “social harmony,” easing the congestion of the coastal cities and building up the interior. 

These benefits present an obvious win for workers, but they may also help college graduates, who are now lapsing into under-employment.  The number of graduates increased from 9.5 million in 2000 to 37.8 million in 2006.  This trend is likely to continue and, very soon, China’s economy will have to accommodate this rising class of educated young people, offering them the kinds of opportunities for which they have prepared.The key is increasing domestic purchasing power to stir service jobs and diversify the jobs base

Viewed from this perspective, a RMB appreciation would right the imbalances in ways that interest rate hikes and erratic price controls cannot.  Raising interest rates further will pull in more capital, exacerbating the problems caused in the first place by China’s FX intervention.  And the pricing controls imposed by China’s government have actively harmed business, as firms shy away from long-term contracts and cut quality. 

Indeed, the lapsed, drawn-out nature of the yuan’s rise has only attracted “hot money” keen for further appreciation –which has in turn further fed the surpluses that now pressure the exchange rate. As Tsinghua University Professor Patrick Chovanec has stated, “The artificial suppression of the RMB is what brings in ‘hot money,’ betting that China’s currency dike will either spring a leak or collapse.”

In January, MIT’s Simon Johnson stated that the yuan will replace the dollar as the world’s reserve currency in twenty years. Of course, twenty years ago, pundits spoke of the Japanese yen and the Land of the Rising Sun in much the same tone of impending ascendancy. 

Japan’s experience in the 1980s offers an important lesson to China today, though it is not the one commonly assumed.  Often in China, the lesson of Japan—crystallized during the 1997 currency crisis—is simply: “Do not listen to the West. Do not appreciate your currency, as it will bring ruin.”  

But the real lesson of Japan is a bit more complicated.  It is that the FX intervention and a protected, politically-ingrained export regime had the effect of generating huge domestic liquidity that was not appropriately sopped up or routed. 

The money found its way into overcapacity because the complete dominance of the export industry—and the relative immaturity of other business sectors—insured it would.  The money found its way into asset inflation because few other venues were available.

The risks built up and were stored in the system as a whole.  But everyone was confident it was temporary.  If they just kept the lid on long enough and kept doing the things that had been so successful for so many years, it would all work out.

To avoid the mistakes of Japan, China must re-circuit its economy for domestic growth, balancing out the needs of the exporters with those still-nascent sectors critical for the future.  It must push back on the entrenched agenda of the coastal cities in favor of the emerging needs of the inner provinces. 

A stronger yuan will help expedite this next stage in China’s economic future.

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Michael Cheah is a senior portfolio manager at SunAmerica Asset Management and an adjunct assistant professor at NYU's Global Affairs program. From 1991 to 1999, he served as the chief representative in the Monetary Authority of Singapore’s New York office.

Sean Daly is associate director of global strategy at Alpha Creative Capital, a New York-based investment advisory group. More of his articles can be found here.

[Photo courtesy of Flickr user EdZa]

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