China lets the yuan rise—but how far?
The Economist | July 22nd 2005
http://www.economist.com/agenda/displayStory.cfm?story_id=4199196
China has revalued its currency, the yuan, and linked it to a basket of
currencies—though it is not yet clear how far it will be allowed to rise.
The move may ease trade tension with America, though China's slowing
economy, which is boosting its trade surplus, may reignite the spat*
SOONER or later, it was going to happen, and on Thursday July 21st it did.
China abandoned the 11-year-old peg of its currency, the yuan, at 8.28 to
the dollar. From now on, the yuan will be linked to a basket of currencies,
the central parities of which will be set at the end of each day. And the
currency has been revalued, although by nothing like as much as America and
others have been demanding: the yuan's initial central rate against the
dollar was shifted by just 2.1%, to 8.11.
So far, it is not clear exactly how the new system will operate. The Chinese
called it a "managed floating exchange-rate regime", which may well imply
more management than floating. Neither the currencies in the basket used to
set the level of the yuan, nor their weights, have been disclosed. The fact
that the Chinese have acted at all is important. But the eventual economic
and political effects of the revaluation will depend on how far and how fast
the yuan moves from now on. In Friday's trading it barely budged—and in fact
closed a fraction below 8.11 to the dollar, suggesting the authorities are
keen to damp down market expectations of further rises.
Such a slight initial revaluation is unlikely to do much to slow China's
fast-expanding economy. The day before the currency regime changed, the
country's official statisticians said that GDP in the second quarter of 2005
was 9.5% higher than a year before—more than most pundits had forecast and
only a shade less than the figure for the same period of 2004 (see chart
below). Growth rates of industrial production, ahead by 16.8% in the year to
June, and investment in fixed assets, up by 25.4% in the first half, year on
year, have both eased from their levels at the end of 2003, but remain
strong. Inflation, as measured by the consumer-price index, is mild. It slid
to 1.6% last month, down from 5%-plus a year ago.
In truth, the economy is slowing more markedly than these (highly suspect)
official figures suggest. Many economists say that China has an
institutionalised bias to over-reporting growth at the bottom of a cycle and
under-reporting it at the top, to reduce the volatility of the numbers.
Judged by physical indicators, such as electricity consumption or freight
volumes, GDP growth probably peaked at over 12% in 2003 and should slow to
8% by 2006. Since China's macroeconomic growth is driven more by fixed
investment than by household consumption (which dominates in the West), it
is especially vulnerable to any slowing of corporate investment or public
spending on infrastructure.
"In investment cycles," says Andy Xie, Asia economist at Morgan Stanley,
"the leading indicators are profit margins, product prices and property
prices, which forecast corporate cash flow or ability to borrow." These
three indicators are slowing. For the past five years, Chinese industrial
firms have enjoyed record profit margins as revenue growth has outpaced the
increase in wages and raw-material costs. In 2003 and 2004, industrial
production and sales grew at an annual rate of nearly 30% in real terms,
analysts estimate, but in 2005 the pace has slowed to around 15%. With
commodity prices high, companies' margins are being squeezed: overheated
industries such as cars, steel, cement and basic materials are suffering
especially.
Property prices are also moderating after a period of extraordinary growth,
particularly in big cities. Shanghai house prices, up by half since 1998 and
by almost 10% in the first quarter of this year, have fallen back by 10-20%
since mid-April. Transaction volumes in most urban centres have also
dropped, because the government has imposed a property-sales tax and
tightened mortgage requirements.
**
Overall, however, China seems to be managing the soft landing that it wants.
The authorities have acted earlier and more decisively than they did in the
mid-1990s, curbing growth before it gets out of hand. Policymakers have also
been more sophisticated, targeting selected sectors with administrative
restrictions while shifting to market-based measures, including last
October's increase in interest rates, to rein in money and credit growth. A
dearer yuan—but much dearer, probably, than after this week's move—would
give the economy another downward nudge.
In addition, the economy is looking better balanced: there are signs that
consumer spending is doing more to support the economy, alongside fixed
investment and exports. Rising incomes are boosting households' spending
power, lifting retail sales by 13% in the first half of the year, compared
with the same period of 2004. And the countryside is finally playing a part:
after six years of lacklustre growth, rural incomes rose by 12.5% in the
first half.
That said, China's policymakers cannot afford to rest on their laurels. On
the one hand, there is a risk that the economy will steam away again as
spending for the Beijing Olympics in 2008 takes off. On the other, the vast
amount of manufacturing capacity built up over the past few years means that
a slightly sharper slowdown, perhaps triggered by lower growth in America,
could tip the country back into deflation. Already, a staggering nine-tenths
of manufactured goods in China are thought to be in oversupply.
In the short term, the biggest worry is that China becomes a victim of its
own international success. Until recently China has been a powerful engine
driving the world economy. If it slows, existing political and trade
tensions could still worsen. Thus an unfortunate side effect of China's
attempts to cool its domestic economy has been an exploding trade surplus,
because import growth has softened while exports have remained robust. In
June, China's exports rose by 30.6%, year-on-year, while imports grew by
just 15.1%, widening the monthly trade surplus to $9.7 billion. The
cumulative surplus for 2005 is now nearly $40 billion, more than for the
whole of last year. This year's current-account surplus could reach 9% of
GDP. "Just one year ago, China was the world's fastest-growing importer of
heavy industrial products," says Jonathan Anderson, chief Asia economist at
UBS. "Today, the mainland is actually a growing net exporter, with shipments
of not only textiles but also steel, other metals and chemicals accelerating
visibly."
Slowing imports (of everything but commodities) are bad news for
international companies, at a time when those doing business in China are
already suffering from increased competition and oversupply. And mainland
firms are becoming aggressive exporters of everything from textiles and
steel to electronics and even cars. Ningbo Bird, based in Zhejiang province,
is flooding Asia with cheap mobile-phone handsets it cannot sell profitably
at home.
Revaluing the yuan should make some of the tensions created by all this less
acute. American politicians, in particular, have been demanding a step in
this direction—President George Bush's spokesman welcomed the move. However,
some congressmen have been demanding a much bigger stride. And investment is
becoming as touchy an issue as trade has been. China is no longer using its
huge stock of foreign-exchange reserves—over $700 billion—merely to buy
American Treasury bonds, but to snap up physical assets too. The $18.5
billion contested bid by CNOOC, a big Chinese oil company, for America's
Unocal is causing an uproar in Washington, DC. China's currency move may
dampen calls for trade protection and revaluation for a while. But if its
domestic economy slows and thus becomes less supportive of global growth,
such calls are likely to return soon.
--
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