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Renminbi tests multi-year lows against euro, pound, yen …

December 2, 2004

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The renminbi seems to have reached a new low against the euro today, breaking through the low set yesterday before a very brief little rally. Every time the renminbi-dollar tumbles, I am reminded why a country with a current account surplus that is attracting signficant net FDI inflows (China) should not have a currency tied to a country with a large current account deficit that is, alas, not attracting net FDI inflows (the US) -- though if IBM sells its PC business to a Chinese firm, maybe other Chinese firms will start to buy the US distributors of products now mostly made in China. That is one way of generating equity financing for our trade deficit.

The dollar’s fall is clearly a part of a global rebalancing story. But I have yet to see a global rebalancing story built around a falling renminbi.

I have a serious point behind bringing this up, again and again. I increasingly suspect that China missed the moment to move from a dollar peg to a basket peg. Had China pegged to a basket back in 2002, and had it given the euro say a 25% weight in the basket, the euro’s roughly 40% rise against the dollar would have produced a 10% rise in the renminbi-dollar. Probably not enough, but at least a move in the right direction. Shifting to that kind of basket now probably won’t have as much of an impact. I sort of doubt the euro is going to rise another 40%. That certainly would not do much to bring about a balanced fall in the dollar -- the dollar would have fallen by something like 80% v. the euro, but only 10% v. the renminbi. That is an outcome that does not make economic sense.

The yen has not moved as much as the euro against the dollar, but the same basic point applies. If China waits until after everyone else lets their currency adjust before moving to a basket, the move to the basket won’t generate much change in the renminbi-dollar unless the non-dollar component currencies of the basket rise even more against the dollar. If China rejiggers its peg in a way that limits the renminbi’s rise, the basic dyanmics of the current system won’t change: China will still run a trade surplus, attract lots of direct investment as well as more specultative inflows. It will still accumulate massive reserves.

To contribute meaningfully to global rebalancing, I suspect, China needs to revalue against the dollar (undoing some of the renminbi’s depreciation against the euro) as it moves to a basket peg. A basket alone won’t cut it -- even leaving aside the point that some currencies in China’s likely basket themselves are informally pegged to the dollar.

China may have waited too long in a second sense as well. The longer China waits, and the more other currencies adjust against the dollar, the larger the expected future rise of the renminbi, and the stronger the incentive to place a speculative bet the renminbi will rise. China says it does not want to reward speculators by moving in response to speculative pressure. But by pegging to the falling dollar, it is only strengthening the incentive to speculate.

The pace of China’s reserve accumulation has picked up recently, to nearly $15 billion a month -- more than China really would like. Remember, the US trade deficit is currently $50-55 billion a month, so if all Chinese reserves were placed in dollar assets, one creditor -- the People’s Bank of China --would single-handedly be covering a bit more than a 1/4 of the monthly US trade deficit.

I should not criticize a Business Week article that cites a true expert on all this (my co-author Nouriel Roubini). But a couple of points in the article struck me as a bit off:

First, lower recorded purchases of Treasuries do not necessarily imply less central bank support for the dollar. They might imply that Asian central banks are purchasing Treasuries indirectly, in ways the US reporting system does not measure, or are buying other dollar assets. For example, if a foreign central bank places a dollar deposit in a London bank, and the London bank then buys dollar securities, it shows up in the US balance of payments statistics as a private purchase of Treasuries.

Second, the argument that "Even though China still needs to buy Treasuries to offset investment inflows, that need is less urgent than before. In recent months, analysts say, China’s repeated insistence that it will not change its currency peg soon apparently has helped stem the China-bound surge of speculative money. That means Beijing doesn’t have to buy up as many dollars" does not seem to be backed up in China’s reserve data. As I argued earlier this week, reserve inflows are now averaging $15 billion a month in the third quarter, up from the $10 billion a month typical earlier this year.

Not all that reserve buildup necessarily is going into dollars, but I still suspect that it is hard to peg to the dollar if you are not willing to buy dollars to support the peg. So I am curious if anyone in the market has observed Chinese buying of significant amounts of sterling and euros -- more than say $10 billion in the third quarter, when China’s overall reserves went up by $45 billion ($10 billion is a bit more than 20% of the total reserve increase). After all, China could try to change the composition of its reserve portfolio without selling its current dollar assets by only buying new euro, sterling, yen and other non-dollar assets as its reserves increase. It is hard for me to judge the credibility of the source for Business Week’s argument that China already has started to diversify its reserves in a meaningful way.

Finally, suppose that China is pulling back a bit and providing less financing for the US. As the Business Week article suggests, hedge fund buying could have helped to support the Treasury market over the summer as China pulled back. But a US hedge fund that funds itself by borrowing from a US bank cannot, by definition, provide the external financing needed to finance the trade deficit. Even if the hedge fund set up shop in the Caribbean, it still has to borrow dollars from US banks (an outflow) to buy Treasuries through a Caribbean offshore center (an inflow). There is no net foreign financing. If China is lending its reserves to Europe rather than to the US, some other foreign investor had be lending to the US to cover the US trade deficit -- perhaps the major oil exporters, who saw their dollar earnings go way up over the summer?

The US can run a current account deficit if foreigners stop buying treasuries and start buying other US assets, but not if foreign demand for all US assets dries up. This should all be a lot clearer when the Q3 data on capital inflows and outflows becomes available in mid December.

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