Thursday, May 20, 2004

China Watch: Monetary Policy and Foreign Capital

The Economist in its "World Economy" piece, discusses the dilemma of central bankers in the People's Bank of China.

Will a measured pace be quick enough? In the 1980s and 1990s, the Fed pursued a hawkish doctrine of pre-emptive strikes against any inflationary pressures it could espy, even if they did not yet show up in headline consumer prices. If you waited until you could see inflation, so the doctrine went, it was already too late. Now, some are asking whether the Fed has fallen “behind the curve”. In fact, the Fed has advertised its behind-the-curveness at every opportunity, telling the markets that rates would stay low for a “considerable period” and that it could be “patient” before raising them. Last year, the Fed felt that deflation was a remote but disturbing possibility; a little inflation would provide a welcome cushion against falling prices. It therefore made a strategic decision to stay behind the curve, making sure that modest inflation had returned before it tightened monetary policy.

The Chinese monetary authorities cannot afford such patience. In recent months, they have pulled on one lever after another in an attempt to stop the overlending and overinvestment that threaten to destabilise the economy. Reserve requirements for banks have been raised three times since last summer, to no avail: banks still managed to lend 21% more in the first quarter than a year ago. On Friday, the Chinese authorities ordered financial institutions to “immediately stop fresh credit” to projects in a long list of sectors that are growing too fast for comfort.

Some media reports had suggested that the Chinese authorities might raise interest rates for the first time in nine years as soon as the Golden Week holiday ended last week. But raising rates could break China’s brittle state enterprises and lure in more speculative capital from abroad. China’s monetary policy must also be guided by the need to maintain the yuan’s peg to the dollar. Until Mr Greenspan raises interest rates, China’s monetary authorities will find it difficult to do so.

They clearly feel that the growth of credit in the economy is unsustainable at its current pace. Either it slows at their behest, or it will collapse of its own accord. Given that China accounted for about a third of the growth in the world economy over the past three years (in purchasing power terms), a serious credit crunch in the Middle Kingdom could also spell trouble for lands to the east and west. Japan, in particular, owed as much as 37% of its GDP growth last year to China, according to Goldman Sachs. It is not quite so dependent now. But if China were to stall, the economic pessimists would be quick to reclaim Japan as their native land. [emphasis added]


The Korea Times discusses the theoretical economic impacts of China's currency policy as of Feb 2004.

So it is nonsense to declare before the fact that China's currency is undervalued. We can only know once all economic players can decide on where they wish to place their financial assets. Given the relatively high rate of growth in China's money supply, there could be considerable pressures for the yuan to depreciate.

This is because a rate of growth of the money supply that exceeds the growth rate of economic activity tends to cause the rate of exchange to fall. Even if exchange rates are fixed but capital can move freely, capital flight from the country tends to put pressures on to end loose monetary policies.

When exchange rates are determined by supply and demand, imbalances can continue for a long time only if most central banks coordinate their policy stances. Once they stop following similar monetary policies, an exchange value of a currency can drop sharply. In the worst case, the collapse of the exchange rate can trigger a severe shock to the real side of the domestic economy.

What is happening with respect to international valuations of the dollar at the moment is that America's central bankers are pumping more money into the system than are most of its trading partners. So, the dollar will continue to weaken until the rate of increase in new money into the U.S. economy no longer exceeds domestic economic growth. And it will have to come into line with the pace of monetary expansion followed by central banks in the rest of the world.


So the story is that the central banks can maintain their current rate of exchange if they coordinate their policy. However, the Federal Reserve is allowing the dollar to fall through relaxed monetary policy and not tightening in the face of falling confidence in America's future financial stability from its structural deficit. Where is the foreign capital putting its money however? On a revaluation of the yuan upwards against the dollar. (China.org)

That report was as of September of last year, but this May 2004 Asia Times online article rehashes out the same problems with "hot money".

Hot money
Hot money is outside investment looking for a quick profit. It is liquid, short-term, and invests in overheated sectors to harvest the largest gains. For instance, profits on investments in the steel industry increased by more than 100 percent year over year in the first two months of 2004.

By calculating China's trade revenue against its total foreign reserves, we can estimate that the amount of hot money flowing into the country in the first quarter this year may amount to as much as US$30.9 billion, for an increase of 25.6 percent over last year, which is no small feat considering that China's foreign reserves increased by 57 percent last year.

Because China keeps the yuan pegged to the US dollar on about a 0.3 percent band, the central bank must sell yuan and buy greenbacks, which, given the increasing foreign currency coming into the country, will create more money supply. In 2003, for example, the base money supply in China increased by 748.4 billion yuan ($90.52 billion), of which 685 billion yuan, or 91.5 percent, came from an increase in official foreign-exchange reserves.

Furthermore, the central bank needs to sterilize foreign-exchange reserves by selling treasury bonds, and to sell more treasury bonds it will have to raise interest rates, which only encourages more hot money as speculators change their dollars to yuan in anticipation of a revaluation. There investors wait, collecting higher interest rates until they can sell back their yuan at costs below what they paid. Meanwhile, China's economy continues to boil with overinvestment, and inflation in underinvested sectors steams with the excess money on the market.


It's doubtful though that the investment money by itself can force the hand of the Chinese government. Unlike the Mexican peso devaluation crises of the nineties, the Chinese government is representing a MUCH bigger economy and always has the option of maintaining the peg by simply printing more money. What it cannot do however is prevent that printed money from flooding its economy and creating an asset inflation bubble and a catastrophic pricking of it later. In other words it get's to choose between a 'hard landing' and its currency peg, with the investment money flowing in betting on a revaluation upwards of the yuan. On the other hand, a sudden precipitious drop in the Chinese economy could create a capital flight situation where that "hot money" flees for the fire exit all at once.

The only real way out of this is if the US Federal Reserve is accomodating and raises interest rates so that the Chinese can also raise interest rates. However the Federal Reserve has chosen to protect US GDP growth. The result has been the Chinese threatening to move from a US dollar peg to a trade-weighted basket of currencies. This move would expedite a diversification of the Chinese foreign reserve assets into other currencies such as the Yen, Euro, and of course gold.

The problem is that the euro is already "overvalued" relative to the dollar because of the past two year's depreciation of the greenback. In addition, the yen is being kept at about 132 Yen to a US dollar by continued BOJ intervention. If China moved to buying Yen, the Japanese government would have to print even more Yen in order to keep it from moving up versus the dollar. Either that or diversify their own holdings of US Treasuries that are approaching a stupefying seven hundred billion dollar level and greater even than China's.

There's a saying. "If somebody owes you a thousand dollars, then it's their problem. If somebody owes you a million dollars, then it's your problem." Well the United States owes both China and Japan a combined trillion dollars of debt that they are holding in outstanding short term Treasuries!!!

What is the likely outcome of this situation? It's hard to tell for sure, but many speculators are betting on a yuan revaluation against the dollar upwards. Furthermore and more importantly, this seems to be the unofficial policy of how the Federal Reserve Board and the Open Market Comittee are dealing with the problem of the current accounts balance. They seem to have come to an agreement with Treasury to step into a position of protecting domestic GDP growth and letting the chips insofar as inflation, oil prices, and currency valuations fall where they may.

In that case, if we have truly divined the intention Greenspan and co. seeing as the prudent policy always has been to "Not fight the Fed" then we would be well advised to predict an upward movement in the yuan, yen, and other currencies against the dollar and suggest that oil, gold, and inflation should all increase in absolute pricing.

Given the mixed strategy in play, with the central banks seeming to try to spread about the damage maximally a 10% price move would be the prudent prediction for the upcoming year.

However, unexpected events can occur. If for instance America should suffer a catastrophic terrorist attack or the People's Bank of China in attempting to prevent a hard landing give up and let the currency peg unwind where it will or the Bank of Japan be forced to liquidate and diversify its foreign asset reserves to other currencies and gold, then we could see a precipitious price swing of up to 25-30% which is the maximum possible situation. Other contributing factors in such a scenario could be the unwinding of Hedge Fund trades that get squeezed by the Federal Reserve's amply telegraphed interest rate rises that may exacerbate the instability in Financial Markets. In addition, there may be smaller catastrophes such as the junk bond market going belly up, various derivative tragedies including in otherwise safe Money Market Funds that have taken to dabbling in them to boost returns in a low interest rate environment, and the unwinding of short hedges against gold and gold leasing arrangements.

The story is mostly to expect an extremely turbulent financial market in 2004. By 2005 it should have stabilized until then, but certainly 2004 with the US Stock Market turning over and the Asian Stock Markets falling certainly not a nice play to be if one is a long term investor. It is however a speculator's hey day and shall remain that way until fear once more triumphs over greed.

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