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A Well-Timed Currency Kowtow

John Lee

The statement by the People’s Bank of China Saturday that it will again insert more “flexibility” into its exchange-rate regime is being heralded as a big economic move. In reality, it’s more about deflecting global attention away from China’s currency policies in the lead-up to Group of 20 meeting in Toronto next weekend than it is about Beijing’s determination to fundamentally rebalance its growth model away from exports and toward domestic consumption.

Beijing accepts that a large reevaluation of the yuan upward versus the dollar is in the country’s long-term interest. As Premier Wen Jiabao himself admits, China’s “unbalanced” economy depends too much on exports and fixed investment and not enough on domestic consumption. China imports around half of its basic consumer goods as well as fuel. Making imports cheaper through currency reevaluation would be one way of enhancing citizens’ purchasing power.

China has also come under strong political pressure from the United States to revalue its currency upward to correct trade “imbalances.” Senator Chuck Schumer is threatening, as he did in 2005, to whack Chinese exports with duties if the yuan isn’t appreciated soon. President Obama underlined this call last week in a letter to the Group of 20 when he underscored “market-determined exchange rates are essential to global economic vitality.”

Seen in that light, China’s announcement can be seen as a political salve—because economically, there are sufficient clues in Saturday’s statement to believe that any exchange-rate adjustment will be insignificant. No timeframe was given for any move, and the statement ruled out “large-scale appreciation.” As from 2005-2008, a more “flexible” yuan exchange rate will likely only mean methodological tinkering with the make-up of the basket of currencies on which the peg is based. Beyond the statement itself, there are several reasons why any significant yuan reevaluation is unlikely in the foreseeable future.

First, a surprising number of Communist Party officials believe that Washington is attempting to manufacture a Chinese slowdown by pressuring Beijing over its currency. These officials recall Japan’s experience in the 1980s when Congress struck a remarkably similar tone. Tokyo eventually signed an accord with Washington in 1985 to revalue the yen upwards. The dollar fell to 160 from 240 yen over the next two years, but the current-account imbalance between the two countries was unaffected. When Japanese growth subsequently slowed, Tokyo boosted government spending and lowered interest rates, leading to the rise of a real-estate bubble that eventually burst and is still haunting that economy today.

China has its own property-market bubble to deflate following record government spending and bank lending, much of which state-controlled enterprises and local government officials have used to invest in real-estate assets. Housing starts almost doubled in late 2009 from a year earlier and property prices in cities such as Shanghai and Beijing have risen around 50% in a matter of months. Beijing can’t afford a further slowdown in its exports since it is already committed to deflating asset bubbles by decreasing government spending and bank lending that has propped up its economy since the 2008 financial crisis.

Second, Beijing still cares more about creating jobs at home than it does about macroeconomic rebalancing. Although official unemployment hovers between a respectable 4-5%, these figures measure less than one-tenth of the Chinese workforce. Local officials have privately admitted to me that joblessness is likely more than double the official figure. According to official figures, there were over 127,000 instances of “mass unrest” in 2008, up from 87,000 in 2005. The vast majority of these arise due to job losses, or inadequate or unpaid wages, in addition to illegal land seizures. An estimated 20-40 million export-related manufacturing jobs were lost in the year following the Lehman collapse, which explains why Beijing abruptly put a stop to the yuan’s gradual rise against the dollar that occurred from 2005-2008.

The regime can hardly countenance any further damage to the export sector. Beijing conducted extensive stress tests on over 1,000 export companies as recently as March 2010 to determine the effects of any significant yuan appreciation. The majority of firms examined were surviving on profit margins of around 2-4%. The results suggested that for every 1% in the yuan appreciation against the dollar, the profit margin of labor-intensive exporters would decline by around 1%, giving the central bank little room to move.

Furthermore, government policies enacted during the global financial crisis have worked to strengthen the state sector at the expense of the private sector. Between 80-90% of the 2008-2009 stimulus and bank loans were offered to state-controlled enterprises, according to official statistics. While the state sector grew from 2008 onward, the private sector has shrunk in both relative and absolute terms. This is important since private businesses both in export and nonexport sectors in China are doubly as efficient at job creation than the state-led sector.

Beijing’s Saturday announcement ignores the pleas of its own economists, who have consistently counseled leaders to liberalize the yuan or at least let it rise substantially. Given the obsessive but understandable focus on employment, this would first require more emphasis on China’s vibrant private enterprise to drive job creation, leading to a gradual loosening of the Party’s grip on economic power. Unfortunately, Beijing is unwilling to take such a risk.

Far from a new era of global rebalancing, the latest People’s Bank of China statement is better understood as a well-timed kowtow to relieve the political pressure on President Hu Jintao to “do something” about the Chinese currency prior to his arrival in Toronto Saturday.

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