China's yuan set to reverse course

By Kosuke Takahashi

TOKYO - China, faced with factory closures and slowing export growth as the global economy slows, is apparently prepared to weaken the value of its currency against the US dollar in defiance of a key policy goal of the United States, even as US Treasury Secretary Henry Paulson visits Beijing this week.

A weaker yuan, which would signal an about-turn by Beijing after three years of appreciation, will help to hold down prices of China's exports, raising the likelihood of further increases in its already contentiously high trade surplus with the US. At the same time, a lower yuan will make imports to China from the US more expensive at a time when American workers are fast losing jobs



as factories there close on falling demand at home and abroad.

Paulson is expected to press for a stronger yuan in talks starting in Beijing on Thursday, just three days after the Chinese currency posted the biggest decline in value since the nation scrapped a fixed exchange rate in 2005.

The US initially welcomed China's July 2005 decision to remove the peg tying the value of the yuan to the US dollar and link the yuan instead to a vaguely defined basket of currencies. Pressure soon grew in Washington, however, for a faster rate of appreciation as the US trade deficit with China continued to mount, sucking ever-more dollars into the Chinese treasury.

A body of US legislators, notably Senators Lindsey Graham and Charles Schumer, and their supporters argue that China has maintained an artificially weak yuan to give its exports an unfair pricing edge in world markets.

China allowed the pace of yuan appreciation to increase during the first half of this year, under pressure from US and European countries. But the appreciation essentially stopped in July, followed by a sharp depreciation in recent days.

Paulson, who is in Beijing to take part in the fifth round of the so-called "Strategic Economic Dialogue (SED)" with China that he initiated in 2006, used previous such meeting to switch the focus of the gathering from the strength of the yuan to other issues.

As recently as December 2, Paulson said the Chinese had been "very responsible partners and stakeholders and have continued to stand by us and stand by our debt". The 20% appreciation of the yuan against the dollar since 2005 has been "important and significant".

The apparent reversal of the Chinese policy regarding appreciation now looks likely to put the yuan back to center stage in the Sino-US relationship, just when Paulson's authority is weakened as he prepares to leave office in January.

This week, the yuan continually hit the bottom of its permitted daily trading band, which extends 0.5% on either side of a midpoint. The yuan traded at 6.8838 to the US dollar as of 2.30 pm in Shanghai Thursday, after dropping as low as 6.8845 and down from 6.8830 on Wednesday. That put the currency near its lowest since June 17, according to the China Foreign Exchange Trade System. The currency hit a record high of 6.8099 on September 23.

The yuan may fall to 8.06 per dollar in one year, Lu Zhengwei, an economist at Industrial Bank Co in Shanghai, told Asia Times Online.

"This is the beginning of the yuan's depreciation," Lu said. "The yuan is set to reverse course. Its slump signals the central bank has changed its policy to one of support for a weaker currency. For developing countries such as China, economic growth prospects are most important. China's exporters are facing tremendous difficulties. A 10% depreciation would help more of them to survive."

Paulson's leverage on the issue is considered limited as China is already the biggest foreign holder of US Treasuries, surpassing Japan. In the event of a dispute, a strong move by China to reduce its Treasury and US corporate debt holdings could severely undermine already weakening global confidence in the US financial system. It would also threaten an end to the dollar standard system from which the US has benefited since the start of the 1944 Bretton Woods regime.

"There is widespread speculation Chinese authorities will change their stance toward the weaker yuan policy," said Masashi Kurabe, senior assistant general manager and head of trading group at global markets division for the East Asia Region at Bank of Tokyo-Mitsubishi UFJ Ltd in Hong Kong, a unit of Japan's largest publicly traded lender by market value. "So many local companies are in a rush to buy the dollar. And there are almost no sellers, excluding the central bank, because those sellers have no need to be in a rush to sell the dollar for the time being.''

The Chinese currency may move between 6.8 and 7 per dollar in six months on the spot market, Kurabe said. In the off-shore market, the non-deliverable forward rate of the yuan would fall further, he said, because of rising speculation over China's policy shift on the yuan, especially from early 2009.

The yuan may depreciate by more than 6% over the next 12 months according to Thursday's trade in non-deliverable forwards, which are used to bet on future yuan moves. That compares with a 2.6% depreciation indicated by trading last week.

"There has been a lot of attention this week on the recent sharp rise in the US dollar against the Chinese yuan, raising fears of yuan weakness going forward," Ashley Davies, a currency strategist at UBS AG in Singapore, wrote in a client note Wednesday.

"Actually, these developments are a logical extension of the [global financial] crisis, since slowing global growth reduces demand for Chinese exports and hence the need for Chinese intervention to stop rapid yuan appreciation. If the US wishes China to continue purchasing Treasuries, it will have to accept that the Chinese yuan will have to weaken," Davies said. "[T]he days of a combination of appreciating the Chinese yuan and large-scale purchases of [US] Treasuries by the Chinese may be over for now - something will have to give."

In September, China surpassed Japan to become the biggest foreign holder of US Treasury debt, with a total of $585 billion. China's $2 trillion in foreign-exchange reserves (the world's largest, followed by Japan's $1 trillion), are primarily invested in relatively low-yielding US government debt and the until recently considered safe debt of Fannie Mae and Freddie Mac, the two mortgage-finance companies taken over by the US government three months ago.

While speculation at present indicates the scale of any weakening of the yuan will be small, the global consequences of the policy u-turn could be considerable.

"The impact of China's currency devaluation should be very big," said C H Kwan, a senior fellow at the Nomura Institute of Capital Markets Research, a unit of Japan's largest brokerage. "It [could] lead to international competition by currency devaluation - a beggar-my-neighbor policy. It should be hard for China to do that. For China it should be a move of the last resort."

Competitive devaluations have been cited by some writers as a key cause of the Great Depression that started in 1929, leading eventually to the onset of World War II. The 1944 Bretton Woods agreements was originally set out a framework for financial stability that would reduce the likelihood for competitive devaluations and laid the foundations for the post-war economic expansion.

As recently as the 1997-98 Asia financial crisis, Beijing was widely praised for not cutting the value of the yuan as currencies elsewhere in the region tumbled.

Concern over a currency u-turn comes after China other efforts to boost its economy. Last week, Beijing cut the benchmark interest rate by the most in 11 years. It has also unveiled a 4 trillion yuan ($586 billion) stimulus plan to protect the economy from a global recession. China’s economy grew 9% from a year earlier, the slowest pace in five years, in the third quarter, as exports fell along with the global economic slump.

China's gross domestic product growth will slow to 8% in the present quarter from a year earlier, the State Information Center, a think-tank under the National Development and Reform Commission, said in a report published on November 27, the lowest quarterly growth since at least the fourth quarter of 2005.

"For developing countries like China, an 8% growth is not acceptable," Industrial Bank’s Lu said.

China's export growth cooled to 19.2% in October, the slowest pace in four months, prompting a pledge from Vice Premier Wang Qishan to "take all measures" to stabilize overseas shipments, Xinhua News Agency said on December 2. That could lead to a reversal in China's trade surplus.

"There is no such situation that China's trade surplus will keep ballooning, so the yuan may move around the current level of 6.8 per dollar in one year," Kwan said.

China's exports to the US increased 6.8%, to $250.4 billion, in the first nine months of 2008, compared with the same period a year earlier, according to US Commerce Department figures. US exports to China rose at more than double that pace, at 17.3% to $55 billion from January through September. That still left a $195.4 billion trade deficit that some lawmakers argue is hurting American manufacturers.

The US trade deficit with China widened in October to a monthly record $27.8 billion.

Kosuke Takahashi is a Tokyo-based journalist. He can be contacted at letters@kosuke.net

(Copyright 2008 Asia Times Online (Holdings) Ltd. All rights reserved. Please contact us about sales, syndication and republishing.)

source: asia times

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