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[TTHQ Staff]

BEING STREET SMART
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Sy Harding


IS CHINA FOOLING THE WORLD? July 22, 2005.
For several years there have been few concerns higher on the worry list of the Bush Administration, Congress, international central banks, economists, multi-national corporations, hedge funds, and bond and currency traders, than if and when China might finally give in to world pressure and abolish the peg of its currency, the Renmimbi (RMB) to the U.S. dollar. Such a move would make Chinese imports more expensive in the U.S., and U.S. products less expensive for China’s consumers, and would go a long way toward solving the large U.S. trade deficit with China.

In last week’s column, I noted a surprising report that the Bush Administration expected China to abolish the currency peg in August, ahead of a planned visit to Washington by Chinese President Hu Jintao in September.

The U.S. and much of the industrialized world have been pressuring China for several years to allow its currency to ‘float freely’ in currency markets, with the markets setting its value in each day’s trading. Were that to happen, economists estimated the Chinese currency would surge as much as 30% in value against the dollar, increasing the cost of Chinese goods priced in dollars by that much.

However, as I pointed out last week, such a large change would create serious problems for the Chinese economy, and turmoil in currency and bond markets. Realizing that, the U.S. had scaled back its demand for a full float, but wanted the RMB revalued by at least 10% as a first step.

I said in last week’s column that China is not dumb, and I doubted it would move even that much. More likely was a revision that would remove the currency’s direct peg to the dollar, but replace it with a peg to a basket of currencies, with China controlling and perhaps not even revealing, how each currency is weighted within the basket.

China didn’t wait until August, but surprised the financial world this week by announcing it was revaluing its currency as of Thursday (July 21).

But China’s ‘revaluation’ was indeed a baby step, a token move of just 2.1%. China’s official announcement was that it will now “reform the RMB exchange rate regime by moving into a managed floating exchange rate regime.” Note the phrase “managed floating exchange”, the most important words in the announcement. China’s currency will not be floating freely in currency markets. Its exchange rate will be ‘managed’.

The announcement goes on to say that “The People’s Bank of China will announce the closing price of a foreign currency such as the US dollar traded against the RMB in the inter-bank foreign exchange market after the closing of the market each day, and will make that the central parity for the trading of the RMB on the following day.” However each day, “the daily trading price of the US dollar against the RMB will only be allowed to float in a 0.3% trading band around the central parity announced the previous day.”

That small revaluation will have virtually no impact on China’s exports or the U.S. trade deficit in the near term. It’s even questionable whether it will go far in achieving what was probably China’s main goal, of getting the world off its back.

However, at least in initial reaction, U.S. government officials praised the move, claiming success in their efforts to have China de-link its currency from the dollar. The media seemed to also read more into it than is warranted at the moment, warning consumers they will be paying more for toys, sneakers, clothing, and other items made in China. Some analysts are warning investors that the sales and earnings of large discount retailers like WalMart, and Target, will be impacted by higher costs of goods imported from China. Some are predicting that China’s trade surplus with the U.S. will decline sharply, resulting in China curbing its massive purchases of U.S. bonds, which in turn will drive U.S. interest rates up, and bond prices down.

And indeed U.S. bond prices declined almost 2% in the hours immediately after the announcement (only to recover almost half of that on Friday).

Such consequences could result over a period of time, but only if China’s new “managed floating exchange regime” were to allow it, which I seriously doubt. If I am correctly interpreting how the 0.3% daily trading band will work, the RMB could move in one direction a maximum of 0.15% per day. If it were allowed to move that maximum amount every day in the same direction, for the 20 trading days in a month, it would be revalued by 3% a month.

However, at this point the Chinese currency is roughly 30% undervalued in relation to the dollar. The world hoped to see a revaluation of at least 10% as a first step. It got 2.1%, hardly even a symbolic gesture at this point.

Hopefully it is just a first step. But if China chooses to use its new, mostly secret currency system to continue to keep the RMB close to parity with the U.S. dollar, it can continue to postpone floating its currency to any degree, will have fooled the world, and changed nothing regarding its competitive advantage over the rest of the world, and particularly with the U.S.


Sy Harding is president of Asset Management Research Corp., DeLand, FL, publisher of The Street Smart Report Online at www.streetsmartreport.com and author of 1999’s Riding The Bear – How To Prosper In the Coming Bear Market.