China’s move gives U.S. symbolic victory
But Beijing’s decision will not fix the stubborn problem at the heart of a global trade imbalance
A watermelon vendor looks at yuan banknotes at a market in Changzhi, Shanxi province on Monday. China’s yuan rose modestly on the first trading day after the central bank ditched the currency’s two-year peg to the U.S. dollar.Reuters
Barrie McKenna and Brian Milner
Washington and Toronto
Monday, Jun. 21, 2010
Beijing’s surprise decision to unshackle its currency has handed the United States a symbolic victory and an edge in trade, but will not fix the stubborn problem at the heart of a global imbalance: Americans spend too much and the Chinese not enough.
Coming just days before the Group of 20 summit in Toronto this week, China’s announcement appeared timed to take the thorny currency issue off the table and defuse simmering trade tensions between Beijing and recession-weary United States. It may also help cool inflation in China.
And, initially Monday, investors believed the decision to allow the yuan to appreciate would quickly make a difference, as they bid up stocks, commodities and some currencies. The yuan rose to a record high of 6.7971 from 6.8272 yuan on Friday. That’s a move of 0.4 per cent and an abrupt break from the range of 6.83 yuan to U.S. dollar that had held since mid-2008.
But the enthusiasm fizzled in less than one trading session. The Dow Jones Industrial Average fell 8.23 points to 10,442, erasing an earlier 100-point gain.
The sober reality is that massive financial imbalances are likely to continue dominating the global economy.
“The bottom line is that Americans don’t save enough,” said Drummond Brodeur, a vice-president and portfolio manager at Signature Global Advisors in Toronto. “China is the largest provider of savings to the world. Unless Americans save more, the United States is going to have to run a current account deficit.”
The yuan’s modest appreciation may be easily swamped by other, more entrenched economic forces.
The broader problem is the enormous gaps between China and the United States in wage rates, standards of living, savings and consumption. Those stark differences in two of the world’s most important economies figured prominently in the financial crisis, as many U.S. homeowners and consumers were exposed as too reliant on debt to finance their purchases. Many financial institutions were similarly overleveraged.
Though many U.S. consumers have tightened up spending and the housing industry now employs far more rigorous lending standards, imbalances persist as the United States runs a major trade deficit with China, and grapples with massive budgetary deficits that promise to weigh on the economy for years. Gaps also exist between the United States and the other major emerging economies – Brazil, India and Russia. For those reasons, issues of global imbalance are likely to be at the top of the agenda for G20 officials this week, since long-term solutions will be needed to get the global economy on a sustainable upturn.
“The economic impact is really quite marginal,” Mr. Brodeur said of the Chinese announcement. “It’s not going to get the jobs back in the U.S.”
Analysts see China’s currency move as the promised quid pro quo following U.S. President Barack Obama’s decision in April to defer branding China a currency manipulator – a designation that almost certainly would have led to a trade war, with duties on imports from China and retaliation from the Chinese.
Chinese officials are playing down the significance of the currency announcement. A commentary in the government-run China Daily suggested the yuan has become a scapegoat for other global financial problems. If leaders don’t make progress at the G20 summit to overhaul the financial system, “the international community will soon find to its disappointment that its leaders look only for red herrings, rather than real solutions, at a time when true leadership is badly needed,” the newspaper said.
It’s unclear how much more the Chinese are prepared to go or when. Most economists expect something less than a 3-per-cent gain this year. It would take appreciation of 15 or 20 per cent to have any meaningful impact on jobs or exports in the United States and other developed countries, said Daniel Alpert, managing partner of Westwood Capital LLC.
China has a lot of reasons to push up the yuan, including putting a lid on rising wage inflation at home.
But it will have to demonstrate that it’s serious about a more flexible exchange-rate regime, or it could be facing renewed pressure from the U.S. Congress to do more. New York Senator Charles Schumer has already said he intends to push ahead with legislation to penalize China with a 25-per-cent duty on its imports – an apparent warning that many Americans want to see more concrete action from the Chinese.
Most market watchers have concluded that China’s move had more to do with politics than economics.
“Nothing we have read, and nothing in China’s recent history, suggests that a major appreciation … is in the offing,” Hong Kong-based research firm DSG Asia said in a report to clients. “The timing of this move should be principally seen as a belated political concession in advance of a G20 meeting that was promising to get pretty hairy for the Chinese delegation.”
Any thought that China is about to substantially reduce its vast holdings of U.S. Treasuries as part of its strenuous efforts to diversify its foreign exchange reserves was also dismissed as improbable and contrary to Beijing’s political and economic interests.
China could stop accumulating U.S. dollars, but as long as its policy is to maintain a large current account surplus, it must keep buying them, said currency specialist David DeRosa, president of DeRosa Research of New Canaan, Conn. “If they want to export to the United States the way they have been, then either China or someone else has to buy dollars. They can’t export more than they import without buying someone else’s currency or bonds.”
Most observers believe the yuan will be allowed to rise gradually.
“It won’t be a large move,” said Mark Chandler, head of Canadian fixed income and currency strategy at RBC Capital Markets. “We’re looking for a 5-per-cent appreciation through the end of the year.”
That would put the yuan at 6.50 to the U.S. dollar, which analysts say would have no effect on trade flows and little impact on prices.
Treasury Secretary Timothy Geithner is “clearly betting” that the Chinese will let the yuan move enough by November, when he’s due to issue his next twice-yearly report on currency practices, said Tim Duy, a former U.S. Treasury department official and now an economics professor at the University of Oregon.
“If not, Congress will start sharpening the knives,” he added. “The tolerance for Chinese resistance will be almost negligible if this announcement is revealed to be nothing more than smoke and mirrors.”
The trade deficit between U.S. and China
Americans send their income abroad to buy what China makes in its factories; the Chinese save the money. That has been one of the dominant themes in global trade and finance for the past 25 years.
In 1985, the United States sent nearly as much to China as it brought in. By 1990, the U.S. was running a $10.4-billion (U.S.) trade deficit in goods with China (that is, it was importing $10.4-billion more in products from China than it was exporting to it).
By 2008, the figure was $268-billion. In the first four months of this year, the goods deficit with China was $71-billion.
All the while, the Chinese government has been accumulating a vast amount of foreign-exchange reserves. At the end of 1990, Chinese foreign-exchange holdings equalled $11.1-billion. By April of this year, China’s foreign-exchange reserves had grown to nearly $2.5-trillion. (Much, but not all, is held in U.S. greenbacks.)
These figures reflect dramatically different consumer behaviour. The personal savings rate in the U.S. has dropped from 12 per cent of disposable income in the early 1980s to less than 4 per cent today. Chinese households currently have a personal savings rate of nearly 38 per cent.
The G20 approaches
Politically, Beijing’s move appeared aimed at giving China a higher foothold in discussions related to fixing the global trade imbalance at the G20 summit in Toronto. Recent relations between the U.S. and China have centered on the debate over the yuan’s value and the role China will play in global rebalancing. Now, says economist Krishen Rangasamy of CIBC World Markets. “the (U.S) argument that China is not participating in the rebalancing process is moot.”
Keeping a lid on inflation
China is not revaluing because of foreign pressure, Scotia Capital economists Gorica Djeric and David Holt said in a report. Rather, a revaluation of the nominal exchange rate will do the job of tightening policy to keep a lid on inflation, they said. China needs to stimulate growth, particularly by increasing domestic purchasing power. The removal of the peg will help expand domestic consumption levels, traditionally lower than other OECD countries. This will help foster more sustainable, globally integrated growth.
Potential Positive Implications
The move is seen as a step toward fixing the global trade imbalance by spurring growth in Chinese consumer spending.
China’s decision will ease pressure on currencies like the yen, euro, and Australian and Canadian dollars, which were “doing the heavy lifting,” appreciating significantly as the U.S. economy struggled, according to Mr. Rangasamy.
Among businesses, foreign manufacturers of autos and heavy machinery are already seeing gains in share prices. BMW, for example, which imports parts from Germany to plants in China, saw its share price rise. Caterpillar and Komatsu, the world’s two largest heavy machinery manufacturers, both reacted quite positively to the Chinese decision. Consumer and technology firms like GE and Lenovo, with significant sales in China, also look to profit. Emerging markets also look to profit, as production outfits based on cheaper labour move from China to countries like Vietnam and Bangladesh.
Potential Negative Implications
Winners and Losers
There will be a regime shift that will see a new balance of winners and losers, economists said. And, at this point, whether the yuan will actually go up or down in value remains to be seen. This potential volatility may entail frantic speculation, increasing market risk.
There is no guarantee that, freed from its peg, the yuan will appreciate in the long term. The People’s Bank of China said “the basis for a large-scale appreciation of the yuan exchange rate does not exist.”
Commodities likely to rise
Commodity prices are likely to rise. With a stronger currency, the Chinese will buy more commodities, increasing the strain on other countries dependent on oil, for example. In U.S. trading on Monday, uncertainty over the extent of the yuan’s future appreciation led to markets relinquishing early gains. Many seem to be concluding that China’s move was only political after all.
Only Part of The Problem
Global Trade Imbalance
China’s revaluation of the yuan is not a miracle cure for the global trade imbalance. “Countries like China and Germany who are savers need to spend more, and big spenders like the U.S. need to save more,” said Mr. Rangasamy. Xinhua, China’s official news agency, said that developed countries need to stop “eating next year’s food,” and that reform of the international monetary system and alleviating the development gap is essential to rebalancing the world economy.
‘Not a Game Changer’
Global Challenges Persist
David Rosenberg, chief economist at Gluskin Sheff + Associates, said China’s decision is “not a game changer,” and global debt challenges have “most assuredly not gone away” as a result. The last time China allowed the yuan to increase in value, in 2005, he said, it did not prove to be any solution to the trends that would amount to the collapse in the U.S. housing and credit markets, the global recession, and the European sovereign debt crisis. China’s decision will only help to ease global trade imbalances “at the margins,” he concluded.
Yuan revaluation expected to boost commodities demand
But concerns over Europe’s debt crisis and still-fragile U.S. economy should curb price hikes
The currency change is akin to China lifting a trade embargo, which some view as a key step toward a global economic rebound.
“A higher Chinese currency is a very favourable development for the global economy, making Western imports cheaper in China, and ultimately creating jobs, which should reinforce a virtual cycle of growth,” said Bart Melek, a global commodity strategist with BMO Nesbitt Burns Inc.
China is already the world’s largest buyer of such key base metals as copper and aluminum, consuming about 40 per cent of global supply. That share is expected to rise as the currency changes start to settle in.
“The likely gradual revaluation of the yuan in the coming years means that China will be sharing more of its growth with the rest of the world,” Mr. Melek said.
That is expected to boost demand for commodities, and drive up prices of those in tight supply.
However, prices aren’t expected to soon surpass highs reached in April – levels not seen since before the global economic meltdown.
Investors are still nervous about Europe’s rising debt crisis and the still-fragile U.S. economy.
“Those problems are in no way … cured,” said Sterling Smith, an analyst at Country Hedging Inc. in St. Paul, Minn.
“This helps to offset some of that loss, but this is not a watershed, earth-changing thing because the Chinese will be incremental about how they do this, as they are with everything.”
Prices of many major commodities surged early Monday as a result of China’s decision announced over the weekend, but eventually eased on lingering uncertainty over how the change will happen.
Copper, considered a benchmark for economic growth for its widespread use in power and construction, rose 5 per cent to $3.05 a pound (U.S.) on the London Metal Exchange, before closing just below $3. Aluminum, nickel and lead prices also ended the day higher.
Oil rose 64 cents to settle at $77.82 a barrel on the New York Mercantile Exchange, after climbing as high as $78.92 earlier in the day.
While Chinese oil consumption is growing – up almost 10 per cent in May from a year ago – its per capita consumption is still much lower than in the United States. A stronger yuan could help boost oil demand further as auto sales in the country continue to soar.
China’s shift in policy shows its confidence in an economic recovery and that Europe’s debt troubles “will remain contained,” according to Patricia Mohr, vice-president of industry and commodity research at Bank of Nova Scotia.
The rising yuan reversed the trend of a rising gold price. On Monday, gold futures for August delivery closed at $1,240.70, down $17.60 from a record close of $1,258.30 on Friday.
Still, many predict the precious metal will keep climbing as a result of hulking sovereign debt loads, particularly in Europe.
“I think gold has a lot more upside just due to the fear factor,” said Matthew Zeman, head of trading with LaSalle Futures Group in Chicago.