The Yuan Revaluation Train has Left the Station

The most pressing question facing China today is what US President-elect Barack Obama will do on trade issues, and specifically what he will do about the debate on whether the US Treasury should designate Chinese as a "currency manipulator."

It is a major concern, Obama wrote in a letter to the National Council of Textile Organizations released on Oct. 24 that China must stop manipulating the currency. The decision he makes on the Chinese currency may be the single most important one he makes in his first 180 days – at least regarding implications for the global economy. If his treasury designates China a currency manipulator, this could trigger the kind of trade war that has the potential to repeat the history of the infamous Smoot Hawley Tariff Act of 1930, which raised tariffs on some 20,000 import items into the US to record levels and which some economic historians believe played a major role in what would become the Great Depression of the 1930s. Conventional wisdom suggests that while it is impossible to prove Smoot Hawley was responsible for the crash, it is likely to have exacerbated the depth of the ensuing Great Depression.

Designating China a currency manipulator could be the straw that breaks the camel’s back for China’s economy; and, it goes without saying that an economic calamity in China would have negative implications for global financial markets. Even if Obama doesn’t designate China a currency manipulator, the Chinese economy could fall into the sort of negative reinforcing cycle we have warned of, including. slowing growth, rising NPLS, tighter bank lending, and so on.

The cold reality is that it is too late for China to do anything about its currency. The yuan appreciation train has long left the station. With China’s economy slowing and the export sector feeling a great deal of pain already (half of all Chinese toy manufacturers went bust in 2008!), the last thing China can afford is a large revaluation of the currency. Even a small appreciation will be difficult going forward. It would not be a surprise to see the yuan stay in its current trading range for the foreseeable future. Some experts are beginning to forecast that the yuan will even weaken versus the US dollar in 2009.

The key question is whether Obama will figure out a face-saving way to avoid designating China a currency manipulator. This will be very difficult. Donald Straszheim, vice chairman of Roth Capital, was quoted in Bloomberg regarding how difficult it will be for Obama to avoid pushing China hard on the currency.

"Obama will be regarded as another old type politician who promises one thing during the campaign and does another in office if he doesn’t take specific action following his comments to the National Council of Textile Organizations that China is manipulating the yuan," Straszheim told reporters.


That leaves Obama – and the prospects for global trade and the global economy and financial markets – in a very precarious spot. The most recent release of China’s foreign exchange figures for the third quarter indicates that the country’s mountain of foreign currency reserves grew roughly US$100 billion. The focus of commentary in the financial press has been on how the number indicates that hot money flows not only slowed in the third quarter, but are likely to have modestly reversed.

That is because even net of currency effects, the $100 billion is less than the combined size of the current account surplus and FDI inflows in the 3Q08. The US$100 billion reserve accumulation in 3Q08 is lower than the 2Q number of $126.6 billion, which was a decline from the 1Q total of $153 billion.

The slowdown in hot money and in the headline reserve accumulation number is a good thing, all things equal, because it means that the enormous challenge policy makers have faced in sterilizing capital inflows is moderating.

Meanwhile, pundits and Chinese policy makers are pointing out that China remains well insulated from global contagion because the $100 billion reserve accumulation still represents an enormous inflow of foreign capital, which continues to provide a very healthy environment for flush domestic liquidity. If the hot money continues its gradual reversal, and reserve accumulation continues to slow, this will allow the PBOC to gradually regain control of monetary policy.

The trillion dollar question is whether the world can expect hot money outflows to remain gradual and well behaved. Probably not. Hot money flows by their very nature are extremely volatile, and it is unlikely that China will enjoy a well-managed unwinding of what has been a historically unprecedented inflow of foreign capital into the country as evidenced by China’s eye-popping $1.9 trillion in foreign reserves. In the first six months of this year, hot money inflows absolutely exploded when total reserve growth surged a stunning $280 billion, an amazing amount roughly equal to the full year accumulation in 2007, which was double the 2006 total.

In the fall of 2003, we began advocating the idea that a maxi revaluation of the yuan was the only fundamental solution to dampening capital inflows into China’s economy. We argued that a maxi-revaluation of 15-20 percent versus the US dollar was the “least worst” of a number of unpleasant policy options China faced at the time because if China did not use an appreciation of the currency to dampen foreign capital inflows, the inflows would not slow or reverse until a domestic economic crisis forced an inevitable reversal.

Chinese policymakers were (not surprisingly) unwilling to execute such a revaluation of their currency because, like most policymakers, they were not keen on trading what was certainly going to be a painful economic adjustment related to a large revaluation of the currency to avoid some uncertain larger economic reckoning in the distant future.

However, if Chinese policymakers had honestly followed their policy dilemma to its logical end, they would have acknowledged and understood that foreign capital inflows were not going to slow (let alone reverse) into the foreseeable future as long as the Chinese economy kept booming with the highest growth rates in the world.

The great paradox of China’s policy dilemma back in 2004 was this: if they succeeded in neutralizing the effect of capital inflows in the near term, their very success was bound to attract even more capital inflows in the future. Foreign capital inflows were unlikely to slow, let alone reverse, going forward short of a large revaluation of the currency or a domestic economic crisis.


Chinese policymakers eventually broke the de facto peg with the US dollar in 2005, but instead of a large revaluation, they opted for what is a de facto "managed-crawl." The managed crawl has proven dangerously counterproductive as it has only exacerbated the capital inflow problem by providing a one-way bet for “speculators” as manifest in an unprecedented surge in hot money inflows into China and foreign reserve accumulation in the 1Q08.

Ironically, China would have been better off keeping the peg, as argued by Professor Ronald McKinnon of Stanford University in California. Because Chinese policy makers chose to keep the yuan undervalued and only very grudgingly facilitated appreciation, they got hit with the double whammy of both ceding effective management of domestic monetary policy while further fueling foreign capital inflows and an epic credit bubble in the domestic economy is bound to bust.

A large maxi revaluation is out of the question now because the domestic economy is slowing and policy makers are looking for ways to reflate the economy; a large revaluation now would only add to headwinds already adversely impacting the domestic economy.

This past July, we wrote an op-ed published in the Asia Sentinel highlighting the dangerous implications for domestic growth in China of rising automobile inventories. Even though the size of the inventory increase was small in absolute terms, and was thus shrugged off by the experts, we suggested the inventory spike was a possible canary in the coal mine for the Chinese economy.

We have always been on the look-out for evidence of inventory accumulation in China because, for one, inventory accumulation is a telltale sign of an imminent unraveling of a classic credit bubble like the one that has boomed in China over the past four years, and for another, it is one of the few important macro signals that defy government manipulation.

There are growing signs that slowing growth is starting to cause profit erosion and higher inventories in other sectors of the economy besides automobiles, including related industrial sectors like aluminum production. While these trends are still nascent, we believe they are important early warning signals that the China macro boom faces a potentially massive unwinding.

A domestic growth slowdown risks triggering a self-reinforcing spiral of higher inventory, lower profits, higher non-performing loans, weaker bank balance sheets, slower loan growth and eventually even slower economic growth.

This is exactly the scenario China faces over the next six to 12 months if, as seems likely, the global economy slows into recession next year. If our negative spiral scenario is bad enough to trigger a full-fledged domestic banking crisis in China and large-scale capital flight, the next big move for the yuan may just be sharply weaker versus the dollar, not stronger as still assumed by conventional wisdom.

The idea that China's socialist model represents an attractive alternative for emerging markets or, as some experts suggest, even an upgrade over American style cowboy capitalism, will prove to be as fleeting as the idea that Japan Inc.’s industrial planning model was destined to rule the world following the 1980’s boom. China's economy follows the natural laws of market economies just the same as every other economy in the history of capitalism: namely, that monetary inflation-fueled credit booms always result in deleveraging busts.

Sam Baker is director of Asia research for Trans National Research Corporation, a US-based political and economic consultancy specializing in global emerging market research.