The yuan lies in waiting

2009-06-18Asia Times

BEIJING - Pundits in China are scratching their heads over the future of their currency, the yuan, which has been brought to the fore by the present financial crisis. Their thinking has recently become urgent, compared with previous perceptions that the yuan could be kept not fully convertible - and thus shielded from foreign interference - for many years.

Certainly, there will be no problem if the US economy recovers soon and the dollar makes a robust comeback as the world currency. In that case, the yuan can continue to piggyback on the dollar, or with the exchange rate slowly and steadily crawling upward according to the necessities of trade.

Yet, what if the US economy and its dollar do not come back? David Goldman (also know as ATol's Spengler) already made this suggestion: "I believe that China and other Asian countries will decouple from the United States during the next five years, partly because the American economy will remain moribund, partly because American policy will continue to be incompetent, and partly because their own domestic market and financial systems will be able to bear the burden." [1]

He draws his conclusion from a report in the Far Eastern Economic Review about the May 3 agreement on the implementation of the Chiang Mai Initiative (CMI), involving the 10 members of the Association of Southeast Asian Nations and China, Japan and South Korea, known as ASEAN Plus Three.

"These bilateral currency-swap agreements will now be transformed into a single regional pooling arrangement, comprising at least $120 billion in reserves. Twenty percent of the funds will be provided by the 10 ASEAN members and the remaining 80% by the Plus Three countries. The ASEAN Plus Three finance ministers also agreed to create an independent surveillance unit to monitor and analyze regional economies and support CMI decision-making processes."

Actually, this is not the only move China is taking in the direction of diversifying its de facto peg with the dollar, which came back with the crisis last autumn after three years of crawling appreciation from 8.3 to 6.8 yuan to the dollar.

In the past few months, Beijing has concluded yuan swap agreements with a dozen countries. With some, like Russia and Brazil, China will pay yuan in return for a set amount of commodities. In this way, China will hedge future price fluctuations for commodities, which would influence its domestic industry, and these countries will receive payments in a currency that is bound to become more important.

The swap agreements are still minimal. By the end of May, China's central bank had signed swap agreements totaling 650 billion yuan (US$95 billion) with a few countries, including South Korea, Malaysia, Indonesia and Belarus, as well as Hong Kong. Furthermore, in June, Beijing signaled it would be willing to purchase some $60 billion of International Monetary Fund bonds.

These amounts are not very significant. They will barely dent the $2 trillion purse of China's foreign reserves and will not rock the stability of the dollar. Beijing is sitting on about $1.7 trillion worth of US-related bonds in total. China is just too committed in America to try pulling out of it. The dollar's collapse would engender the collapse of China's economy before causing the collapse of the whole global economic system.

Yet, something more significant would be necessary to hedge China's money, which is now at the mercy of America's policymakers. On June 1, during his visit to Beijing, US Treasury Secretary Timothy Geithner promised the security of China's dollar-denominated assets. The Chinese fear that, with all the money pouring in to revive the US economy, inflation and devaluation will ensue, cutting the value of the Chinese-held bonds. His promise is important, but certainly not sufficient.

In a 2005 paper, Blanchard, Giavazzi, and Sa [2] calculated that for the US economy and the dollar, "The effect of the 15% depreciation is then to reduce the ratio of net debt to GDP by 10 percentage points ... This implies that, after the unexpected depreciation, interest payments are lower by 4% times 10 %, or 0.4% of GDP. Putting things together, a 15% depreciation improves the current account balance by 1.4% of GDP, roughly one-third of it due to valuation effects." [3]

Economists saw the beginning of the problem in what they called "the dance of the dollar", it has swung up and down since the late 1970s. They blamed foreign central banks for buying dollars and pegging to the dollar, saying it kept the American currency artificially high, which prevented what should have been a fall in the price of American assets.

"What the foreign central bank is effectively doing is keeping world demand for US assets unchanged by offsetting the fall in private demand. Pegging leads to a steady increase in US net debt and a steady increase in reserves offsetting the steady decrease in private demands for US assets." [4]

Since 2005, their recipe is both a decrease in the exchange rate, and the yuan has indeed appreciated, and a reduction in the budget deficit. It is impossible to think of depreciating the dollar when the United States still needs China and Japan (its second-largest creditor) to keep bankrolling its debt. But the pressure of the sheer computations could become irresistible in the near future, if things get worse or simply do not improve.

For this reason, the Chinese are proposing, at least since last September, to start issuing to America "panda bonds", bonds denominated in yuan that would insure Beijing against currency fluctuations. America so far has turned down the offer, which would limit its room for maneuvering in working with its currency. Yet, the idea did not die in China.

China has too much money in reserves, and there are limited options for what to do with it. China's image abroad is not good, and Chinese companies have no experience managing foreign companies abroad. Therefore, it is unlikely that Beijing will encourage Chinese companies to go on a buying spree abroad as the Japanese did in the early 1980s.

Chinese economists are now playing with a similar idea: yuan-denominated loans to foreign countries, mainly neighbors. This could be a powerful tool to make the yuan stable against future currency fluctuations. If the yuan appreciates, the loan will keep its value and thus the Chinese assets will not decrease; if the yuan depreciates, the increase in Chinese exports would compensate for the depreciation of the loan. In fact, there could be a mechanism inducing each country to keep exchange rates stable.

If neighboring countries accept yuan loans, they would de facto pressure the US to keep the dollar-yuan exchange rate stable, thus helping China in dealing with the US. But it would only work if there were enough incentive - that is, if the yuan loans were substantial enough to make a difference for a country.

The consequences could be huge. A pool of countries accepting these Chinese loans would push China's yuan to the center stage of world currencies. China's yuan could de facto become the currency of reference for international trade. This could further push China to fully liberalize its exchange rate, and thus update its backward domestic financial structures.

Further pressure in this direction could come from sluggish American demand. "If US demand for Chinese goods does not return, China must concentrate on the expansion of the internal market, which, in turn, requires improvements in financial infrastructure (consumer lending, mortgage lending, business loans, municipal finance, and so on). This is very hard to accomplish without convertibility - investors want liquidity and convertibility. Thus, it is the requirements of an internal capital market that would push China toward greater use of the yuan." [5]

These perspectives are very real and could start very soon. China has a lot of money to move around, while US investment looks increasingly scary. Many countries are knocking on China's door and asking for loans. They fret about the dollar's volatility and appreciate the very conservative attitude of China's central bankers.

Here the euro, so far, is no alternative. It has no political head; it is influenced by the difficult ties among different national agendas. Unless, in the next few months, it manages to come up with a coherent and unified long-term proposal about future financial balances in the world, it will de facto be irrelevant.

Japan, America's second-largest creditor and home of the world's second-largest domestic debt, will try to carefully navigate between the currents. It will have to rescue its dollar-denominated assets, but also its large Asian trade, which is possibly becoming more dominated by the yuan.

The real issue is with the dollar. The uncertainties about America's future economic prospects make the dollar objectively volatile. This would be no problem if the euro, yen or British pound were its competitors as reserve money. But because of their shaky economies, these currencies are even more volatile than the dollar.

Yet, if the yuan, with its priming domestic economy, comes to the fore, the whole game is bound to change. The Chiang Mai Initiative can get real, the swap agreements become alluring, and yuan loans become attractive.

This puts more pressure on the US to establish some form of broad financial agreement with China on the dollar. That would limit America's currency options, but it would also hedge America against possible further economic downturns by anchoring the US economy to China's, and it could help stabilize the dollar. If America's economy fully recovers in a timely manner, it will have no significant drawbacks.

Will America do it, then? Actually, this will also depend on how actively China pursues the many financial options on the table. Beijing is in no hurry. It is naturally conservative, and now even more so. It could start to slowly explore its options, while seeing how they are working and how America fares in the next few months. If things go well for Washington, so much the better. If they do not pick up, the US can still talk to China, yet at a different price level.

If in a few months, US economic prospects still look gloomy, China may want to get a higher price for its yuan-dollar agreement.

Then the United States would have an incentive to talk to China as soon as possible. But the game is not only about economics; it is also - or mainly - about politics. Here it's clear to Washington and Beijing that America has many cards up its sleeve. The reality is that China might have to trade part of its economic strength for some of its many political weaknesses. And this is a different, very complicated story.

1. "An Asian Commodity-Based Currency?" June 3, 2009,
2. Olivier Blanchard, Francesco Giavazzi, Filipa Sa, "The US Current Account and the Dollar," May 14, 2005. Blanchard has since become the IMF's chief economist.
3. op cit, p 22-23
4. op cit, p 33
5. David Goldman, in a private exchange with the author. (2009-06-18 Asia Times)


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