Monday, 16 November 2009

Why the CNY could strengthen

Friday saw a widening of the US trade deficit, which apparently surprised the markets. Proving how short a memory the market has, nobody appeared to remember last month's rather disturbing observations that the US consumers again are again bringing their savings rate down. Paired with increased public spending, there should be no surprise that the trade deficit widens. The only thing that should could about an improvement in the trade balance would be a significant upsurge in US exports.

Which takes me to my other point, namely the Chinese exchange rate. Some days ago I wrote that as long as the Chinese decide to have a fixed exchange rate against the USD, there is no need to worry about the financing of the US deficit: China is simply forced to buy USD denominated assets matching the accumulated surplus. If not, the CNY will appreciate.

There are two reasons why the Chinese may in fact be interested in letting the CNY appreciate. One is the US pressure for this to happen, another is the follow-on effects on the Chinese economy.

The US pressure is probably not causing the Chinese leadership too many sleepless nights. Over the past 20 years, Western corporations have been busy de-industrialising, actively moving production to China. There are many reasons for this, and none of them can be remedied by a slightly stronger Yuan. Structurally, the Western world has been busy moving production to China, enticed by very low salaries, the lure of the productivity of freshly minted production capacities, the productivity of the Chinese workers, an attractive model for reinvesting profits and so on. This trend has certainly also been helped by a growing feeling that here in the West, we don't do dirty hands any more. Producing stuff is simply not cool any more. Banking and other service activities are cool.

I am afraid that the Yuan would have to appreciate very strongly in order to compensate for these factors. The fact that China and other Asian countries have become the primary global manufacturing motor will not change even if the Yuan appreciates by half. In this respect, the Chinese leadership has little to fear from the pressures from President Obama.

The other side of the coin is apparently more worrisome. If country runs a strong current account surplus with a fixed exchange rate towards the deficit country, this surplus will manifest itself in a strong increase in the money stock of the surplus currency. Unless the monetary authorities do something, the increased money circulation will drive up prices and in some cases lead to speculative increases in asset prices.

Usually, the central bank of a surplus country will try to offset this by selling government paper in the market, aiming to "soak up" the excess liquidity by so-called sterilising operations. And here is the rub. China does not have a well-developed market for this kind of instruments. Which means that controlling the domestic effects of the huge accumulated surplus becomes more and more difficult. By letting the Yuan appreciate, the Chinese authorities could at least partially offset this effect.

Recently, senior Chinese politicians have joined forces in warning that the low US interest rates are laying the foundation for a new speculative bubble. They are right. Nowhere is that more correct than for countries with their currency pegged to the USD and an inadequate system to control the domestic liquidity. If the Chinese decide to let the Yuan appreciate, this is the reason. US pressure will have little to do with it.

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