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Yuan Rising

By breaking through an exchange rate of 6.50 yuan to the dollar on Friday, China’s currency passed through one of those symbolic milestones beloved of market commentators. Thumbing through our records we see that level was last reached in 1993. A lot of Chinese exports have flowed under the bridge since then.

While a spurt of yuan appreciation usually precedes Sino-American talks (there is a round due in Washington mid-May), the People’s Bank of China seems now to be  belatedly letting the yuan shoulder more of the burden of fighting inflation, by making energy and food imports cheaper. The currency has gained almost a full percentage point against the dollar this month, as much as it was allowed in the whole first quarter. Since Beijing freed the yuan from its dollar peg in 2005, with a near two-year repegging after the global financial crisis hit in 2008, the yuan has gained 27.5% against the dollar under the central bank’s managed appreciation regime. Since it was unpegged for a second time in June 2010 the yuan has appreciated 4.6% against the dollar, though it has depreciated in nominal effective terms.

As the chart below, from the World Bank, shows, the yuan’ effect exchange rate has been trending up if not by as much as the nominal figures for its appreciation against the dollar might have one imagine. REER stands for real (i.e. inflation-adjusted) effective exchange rate (the value against a trade-weighted basket of currencies),  NEER for nominal effective exchange rate. Note the widening gap between the two since mid-2010 during which time exports have been resurgent.

The question for investors now is whether April’s appreciation against the dollar signals a willingness on the central bank’s part to step up the pace of appreciation of the currency in the face of stubbornly high inflation, or, as we suspect, just that it plans to continue to let the yuan rise as it has been doing.

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U.S. Lawmakers’ Effort To Push China Over Yuan Again Going Nowhere

The attempt of two U.S. lawmakers to reintroduce legislation that would  let the U.S. impose emergency tariffs against China if its currency is found to be undervalued, isn’t likely to get any farther than it has on previous occasions, even though its language is toned down from before. There aren’t sufficient Republican votes for such a measure and the Republican leadership’s priorities are more domestic issues. Even if the bill did somehow manage to pass the House of Representatives, as it did last time, it would likely again die in the Senate.

Last week, the U.S. Treasury, in a biannual report to Congress politely delayed until after President Hu Jintao’s state visit to Washington, declined to label China a currency manipulator, but said progress toward allowing the yuan to appreciate was “insufficient”. The yuan has risen only 3.64% against the dollar since it was unpegged from the greenback in June 2010. The currency hit a new high against the dollar on Thursday, at 6.585, displaying its usual upward mobility ahead of a G-20 finance ministers’ meeting.

The ministers convene with central bankers in Paris next week to follow up on pledges made at the G-20 summit in Seoul to move towards market-determined exchange rates and to shun competitive devaluations. The U.S. has been trying to make common cause with Brazil to put pressure on Beijing to accelerate the yuan’s appreciation, and the International Monetary Fund has been dangling the carrot of inclusion in the basket of currencies on which its Special Drawing Rights are based but for which the yuan would have to be freely tradeable. Yet China is likely to hold its line that its currency needs to appreciate gradually to avoid social dislocation, and switch attention to what it sees as the damaging effects of the U.S. Federal Reserve’s quantitative easing and capital flows into emerging economies causing imported inflation.

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Inflating The Yuan’s Value, Not Manipulating It

The U.S. Treasury has danced its way, as is its wont, around designating China as a currency manipulator. In its latest half-yearly report to the U.S. Congress, it says that China’s high inflation means that the yuan’s real (inflation-adjusted) exchange rate with the U.S. dollar has risen by an annualized 10% since Beijing started allowing its currency to rise again against the greenback last June. On a nominal basis the yuan rose 3.7% over that time.

Were the Treasury to declare that Beijing was manipulating its currency, it would trigger retaliatory actions by the Congress, where many believe that it does. That, though, would be a ramping up of Sino-American tensions that neither government would want to deal with, especially in the wake of President Hu Jintao’s state visit to Washington last month that put the relationship on a less overtly confrontational footing.

The Treasury did, however, repeat another of its favorite tunes, that the yuan remains “substantial undervalued” agains the dollar, and that more rapid progress is needed in its revaluation.

China’s real effective exchange rate has appreciated only modestly over the past decade. China’s large increases in productivity in export manufacturing, improvements in transportation and logistics, and China’s accession to the WTO all suggest that the [yuan] should have appreciated more significantly on a real effective basis over this period.

To seek to change that, the Treasury strikes a note of encouragement, rather than chiding:

It is in China’s interest to allow the nominal exchange rate to appreciate more rapidly, both against the dollar and against the currencies of its other major trading partners. If it does not, China will face the risk of more rapid inflation, excessively rapid expansion of domestic credit, and upward pressure on property and equity prices, all of which could threaten future economic growth. By trying to limit the pace of appreciation, China’s exchange rate policy is also working against its broad strategy to strengthen domestic demand. And China’s gradualist approach on the exchange rate also adds to the substantial pressure now being experienced by other emerging economies that run more flexible exchange rate systems and that have already seen substantial exchange rate appreciation.

Beijing’s policymakers know that that to be the case. They are just doing a slow foxtrot with the yuan for domestic social and political reasons, and won’t be rushed into picking up the tempo.

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Unintended Consequences Of Yuan Revaluation

Our man with his ear to the ground moving and shaking the global elite at the World Economic Forum’s annual meeting in Davos sends word that amidst a general half-glass full/glass half empty sentiment towards China’s commitment to revaluing its currency, there is some concern that a revalued yuan against the dollar would be a mixed bag for U.S. firms. U.S. exporters would find their products becoming relatively cheaper in the Chinese market. In the other direction, American firms with Chinese operations would find their exports from China becoming relatively more expensive. Foreign-affiliates account for 54% of all China’s exports, according a finance ministry report last year. Against that, foreign affiliates would also be repatriating higher profits in dollar terms from their domestic Chinese sales, and their margins would be helped by getting cheaper raw materials when those are imported.

It is on the investment rather than trade account that a yuan revaluation may have the greatest unintended consequences. It would become more expensive for U.S. companies to invest in setting up Chinese operations, giving an advantage to those already there. It would also likely boost China’s outward foreign direct investment (FDI), as it lowers the cost to Chinese firms of buying overseas assets. This Bystander recalls that that is what happened in Japan after Washington arm-twisted Tokyo into allowing a 50% revaluation of the yen against the dollar in 1985-87. Japan’s overseas FDI went from barely $6 billion in 1984 to nearly $50 billion by 1990.

In China’s case, the drive overseas is led by the search for natural resources. Manufacturing accounts for less than 10% of Chinese firms’ FDI. Some labor-intensive manufacturers are looking abroad for cheaper labor in the face of rising wages at home; more than 700 Chinese companies had invested in operations in Vietnam as of last July, according to Vietnamese officials. That is a drop in the bucket of the country’s manufacturing cohort, and they are mostly small or low-value-added manufacturers from Guangdong and the provinces bordering Vietnam. Yet a rising yuan could sweep along more in their wake. If Japan’s experience were to be replicated (and Beijing has resisted such a rapid forced appreciation having seen the effect on Japan’s domestic economy), the bigger flood of Chinese firms looking beyond natural resources to invest in access to foreign markets, brands and technology would be likely to prove much more troublesome for Western competitors, and to expand trade friction into investment friction.

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Another Small Step In The Yuan’s Internationaliztion.

Bank of China’s new if limited yuan trading facility for its U.S. customers is another small step in the direction of internationalizing the currency. It is the first time customers can to buy and sell yuan using accounts at the state-owned bank’s U.S. branches, rather than go through Hong Kong. A limit of 20,000 yuan ($3,000) a day can be bought per individual’s account, the same cap that applies in Hong Kong to limit speculation. Business accounts are uncapped.

Beijing has been pushing its importers and exports to settle trade less in dollars and more in yuan, and allowing the development of an offshore market in the yuan. Cross-border trade settlements in Hong Kong grew from an average of 4 billion yuan a month in the first half of last year to 68 billion yuan in October. China Bank of Construction forecast recently that this number could reach 1.6 trillion yuan a month by 2015. However, the trend is more pronounced in the trade with countries other than the U.S.

Nevertheless, it has helped swell the yuan deposit base in Hong Kong to 260 billion yuan at end-November 2010, and the introduction of markets in the currency and of yuan-denominated financial instruments, including so-called dim sum bonds. Trading in the currency was allowed in Hong Kong last July. Daily trading has now reached $400 million. Given $4 trillion is the total of all daily currency trading, the internationalization of the yuan still has a long way to go, but it is clear where it is headed however cautiously.


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China Eases Capital Controls On Exporters

The rules requiring exporters to bring home their foreign-currency earnings by selling them to the central bank for yuan have been an anachronism dating back to when Beijing fretted about capital outflows. Now China sits on foreign-exchange reserves of $2.6 trillion, the rules have gone. A three-month pilot program with 60 exporters has been thrown wide open.

While the idea is to provide another drain tap for the liquidity that is the underlying cause of the country’s inflation and to massage the balance of payments figures, the immediate impact is likely to be slight. For one, the yuan is being allowed to rise against the dollar, so there is no forex incentive for firms to leave their money in dollars right now, and probably not for the years it will take for the yuan to rise to what would be a market-set level. Exporters will have to set off the possible currency appreciation against the transaction-cost savings from not having to undergo the burdensome process of converting their dollars into yuan.

Nor will scrapping the rules do anything to deal with the hot money coming into the country, a more troubling issue for policymakers as it tends to be more short-term and volitive than export earnings. Longer-term, letting exporters manage more of their foreign-exchange earnings will let China’s ambitious multinationals build up war-chests for international operations and expansion.

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G-20’s Seoul Inaction Plan

If there is one thing that can be said about the newly-concluded G-20 summit in Seoul it is that everyone can claim it was a success, without having to do anything immediately about it, and certainly not the same thing. The final communiqué’s wording left open many interpretations of its headline commitments, that the major economies have agreed to refrain from competitive devaluations, that they will get the IMF to come up with indicative guidelines to tackle imbalances, and give emerging economies a bigger say in the IMF.

None of those represent much if any advance from where the G-20’s finance ministers had got earlier this month at their preparatory meeting, but given the gradual drifting apart of the consensus over the coordinated management of the global economy that had formed to deal with the global financial crisis of 2008 and the substantial differences over currencies, trade and quantitative easing going into the meeting (and expressed acrimoniously at times during it, we hear, particularly when Chinese and American officials were in the same room) that was not nothing. But the leaders came up with neither timetables nor hard goals to turn their good intentions, however vague, into actionable policy:  a what, but no when nor how much. (Asking the IMF to look at something next year doesn’t count as a when.)

So on to the APEC summit in Yokohama for many of the G-20 leaders to reprise many of the same economic issues with similar lack of progress. Meanwhile, this Bystander feels, the Seoul Action Plan, for, yes, the G-20’s communiqué lays it out, will be rather like the revaluation of the yuan, all in its own time.

This post was first published on Market Bystander.

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China Gets A Greater Strategic Taste For Gold

There is a whiff of coordination to a couple of published comments suggesting the country should convert some of the dollars it is holding in its foreign-exchange reserves into gold to avoid losses from a weakening dollar. Shao Fenggao, an official at China Construction Bank, writing in China Business News, echoed a similar sentiment expressed by Meng Qingfa, a researcher at the China Chamber of International Commerce, in the International Business Daily, a newspaper affiliated with the Ministry of Commerce, whose minister recently said dollar issuance in the U.S. had gotten “out of control”, exporting inflation to China.

China’s foreign-exchange reserves are the world’s largest. They hit a record $2.65 trillion at the end of September, but gold accounts for less than 2% of the total, an extremely low percentage by global standard. In raw terms, China owns 1,054 tonnes of gold, as best is known; the U.S. holds 8,133 tones. If China did up its gold holdings, it would be doing so after a bull run that drove prices of the metal to new records, but if it did so on any scale, say to match America’s holding, as some officials have suggested, it would reinvigorate the gold bugs who have taken a breather recently. The China effect would be just the same on gold as on any other commodity.

Another straw in the wind of the changing attitude towards gold is the easing of import controls on gold bullion last month, letting Chinese investors buy more on global markets. Beijing used to fret that too much gold coming into the country would mean a drain on its stocks U.S. dollars. Those are less valuable assets to preserve these days, and will only be increasingly so as the yuan strengthens against the dollar. Switching foreign-exchange reserves into gold would also be a move in the direction of strengthening the yuan’s credibility as a global reserve currency — a double reason for buying gold.

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