from Follow the Money

China shifts to a basket peg

July 21, 2005

Blog Post

But the change against the dollar is small.  Very small.

Too small in my view to have much of an economic impact, in any way.  On trade flows.  Or on capital flows.  I would still bet on a further revaluation.

For once, I agree with Stephen Jen:

"``This was the tiniest and smallest move China could make,'' said Stephen Jen, head of global currency strategy at Morgan Stanley in London. ``The motivation for making such a small move is due to political concerns and that the Chinese could buy some time with the Americans.''

China afterall has a substantial, and growing, current account surplus.  The revaluation seems too small to change that.

If Goldman is right, a 2% revaluation v. the dollar (and the world) will slow Chinese export growth by about 2% -- from 30% to 28%.   Or if you think China's export growth would have slowed anyway, from 25% to 23%.   In other words, not by much.

Remember, this is hardly the only move in China's currency this year.  Since China's currency tracked the dollar til now, it already has appreciated by 10% against the  euro.  Since China trades almost as much with Europe as with the US, that move is likely to have a bigger impact on China's trade than the currrent move.

Going forward, though, China's new basket peg means that the renminbi won't always track the dollar.  That makes sense.  The currency of a major creditor (China) should not be pegged to the currency of the world's biggest debtor (the US).

The big question in the short-run is wheter a small move like this will ward off (growing) political pressure to restrict Chinese access to the US market, and parallel pressure to restrict Chinese access to the European market.

Update: Nouriel Roubini is discussing the impact of the renminbi revaluation on the Wall Street Journal's Econoblog.  He also has done an interview with the New York Times.  I also want to join Dr. Drezner in recommending this Michael Phillips article.

Some initial speculation on the impact on capital markets follows below the fold.

I think He Fan of the Chinese Academy of Social Sciences (quoted in the Financial times) has it right: this will strengthen expectations for a further rise in the RMB.

Certainly, Washington may be demanding further revaluations soon, something that Chinese analysts saw as a potential downside to the announcement.

"Such a small adjustment may well intensify the expectation for a further rise in the value of the renminbi," said He Fan, of the Chinese Academy of Social Sciences.   "And by re-pegging the renminbi to a basket of currencies rather than the dollar, we have actually made no fundamental change, as the peg still remains."

Mr He forecast that the next move could be to loosen controls on capital flows and widen the ban in which the renminbi can fluctuate to 1 or even 3 per cent.

Any other moves, if they do come with in the next six to 12 months, are likely to be small, for the same reason that Thursday night's revaluation was only 2.1 per cent.

On top of their desire for only gradual change in the currency, Chinese leaders are acutely sensitive to be seen to be reacting to foreign pressure.

Chinese leaders stressed this in numerous public statements in recent months, one reason why officials in Beijing were relieved that the public pressure from the US has abated since late June.

"There is clearly much better coordination between the US and China," said Mr Gong.

In the short term, however, there is one issue that the two sides cannot co-ordinate and that Thursday's adjustment will barely affect: China's large and growing bi-lateral trade surplus with the US.

The trade surplus has provided the ammunition to Congress for their attacks on the renminbi. President Hu may hope that Thursday night's move will make the renminbi a much smaller target, in time for China to mint a revised strategy to deal with the US.

Richard McGregor's last point also rings true to me: the Chinese are buying time to develop a much broader strategy for managing their (increasingly contentious) economic relationship with the United States.

What does this mean for capital markets?  My gut answer is not much. Why?

Because expectations of a further revaluation will continue to fuel capital inflows (hot money) into China, leading China to keep on adding to its reserves.

A basket peg allows China to hold a basket of reserve assets that extends beyond the dollar more easily.  China is no longer just targeting the dollar.  But it already has a substantial stash of non-dollar reserves -- if 20% of its existing reserves are in the euro, it still would hold $140 billion of euros.  That is maybe 8% of China's 2005 GDP -- and about equal to China's total reserves five years ago.  China won't be able to dump its existing stock of dollars without moving the market.   And it already -- I assume -- has been buying a relatively diverse set of reserve assets at the margin.

It is pretty clear from the US TIC data that China is not just buying Treasuries -- it also is buying Agencies and corporate debt (probably mortgage backed securities). In other words, China has long been interested in holding a relatively diverse portfolio of US fixed income assets, by central bank standards.  And it clear that the TIC data only captures a fraction of the People Bank of China's total activity.  Some of the gap between China's total reserves and what shows up in the TIC data no doubt has been invested in non-dollar reserve assets for some time.

In the near term, though, I suspect that "speculators" will test the central bank -- so speculative inflows into China could well pick up.  That means faster overall growth in reserves, so even if a declining fraction of those reserves go into dollar assets, total Chinese demand for US fixed-income assets could go up.

And if other Asian central banks jump in to prevent their currencies from rising more than the PBOC is willing to allow the RMB to move, total demand from Asia for US fixed income assets could well go up.

Of course, that is not the only thing driving the fixed income market.  US investors could start selling in the anticipation that the current move in the RMB augers the beginning of a broader move, and that, over time, as Asian currencies appreciate v. the dollar, Asian current account surpluses will shrink and capital inflows -- both FDI and speculative inflows -- into Asia will fall, and consequently Asia's long-term support for the US fixed income market will fall.

But i would not expect any actual fall off in Asian central bank support for the US fixed income market from a small move; in the short-run, I think Asian central bank support could actually spike up, because Asian central banks will end up intervening more, not less, as private capital positions itself for the "next" move.

One last aside.  William Polley has noted that China is loosening its capital controls to make it easier for Chinese firms to take money out of the country.  That will facilitate their ability to invest abroad -- and to bid on US firms.    The more Chinese firms invest abroad, the smaller the increase in PBOC reserves.  I consider this a backdoor attempt at reserve diversification (or at least diversification of the overall composition of China's external assets) more than anything else.

For "speculative" purposes, the controls that matter are:

a) limits on the ability of overseas investors to deposit money in RMB in the Chinese banking system/ buy Chinese fixed income securities/ buy Chinese firms.  These controls limit inward inflows. 
b) limits on the ability of Chinese citizens with RMB deposits in China to shift to offshore bank accounts.  This limits outflows.  It also protects the Chinese banking system, in large part by making it possible for interest rates on bank deposits to remain quite low, supporting bank profitability.

I want to dig a bit more, but I currently do not see any sign these controls are coming down.