Global: An Awesome Move by China Stephen Roach (New York) Jul 22, 2005
China’s long-awaited currency adjustment is unambiguously positive for the global economy. Yes, it is a first step -- and a tiny one at that. But it qualifies China as an active participant in the global adjustment process. Up until now, the Chinese were on the outside, looking in, insofar as global rebalancing was concerned. That was a recipe for increased trade frictions and protectionism -- a hugely destabilizing possibility for an unbalanced world. China’s move on the currency front diminishes those risks and could well provide an important kick-start to an increasingly urgent global rebalancing.
I applaud China’s action for three reasons: First and foremost, it derails Washington’s protectionists and the serious threat they posed to geopolitical stability. Admittedly, a 2% revaluation of the renminbi stops well short of the 27.5% adjustment stipulated by the proposed China Currency Act (S. 295) sponsored by US Senators Schumer and Graham. This bill had garnered surprising bipartisan traction in the US Congress and could well have been passed by the upper chamber later this year. In fact, had China not changed its policy by October 15 -- the next scheduled release date for the US Treasury’s bi-annual foreign exchange review -- Washington would have formally declared China as guilty of currency manipulation, and anti-China trade legislation would have passed in a heartbeat. The China-bashers certainly did not get anything close to what they were seeking, but the wind is now out of their sails. US Treasury Secretary John Snow’s statement that he “welcomes” the currency shift makes it unlikely that China will be tainted by manipulator status. As a result, the Schumer-Graham initiative is likely to lose support.
The shift in Chinese currency policy is an important downpayment on the nation’s long-term commitment to a flexible foreign exchange mechanism and an open capital account. China has committed itself to this endgame for years, but up until now, this promise was more rhetoric than action. The 21 July move provides instant credibility to what was at risk of becoming a vacuous pledge. Depending on market conditions and the state of the Chinese economy, there will undoubtedly be more adjustments to come. China recognizes the cost of intransigence -- punitive trade sanctions coming from the US, its largest export market. Given its all-important stability constraint, this is not a risk China wishes to take.
A second reason why this action is a plus is that a small currency adjustment does little damage to China export competitiveness. China has already taken actions to cool off its overheated property sector, and it does not want to risk overkill by crushing exports. Collectively, fixed investment and exports account for 80% of Chinese GDP and are still growing at close to a 30% annual rate. China’s boom would quickly turn into a bust if both of these sectors slowed sharply. A small upward adjustment of the currency should reinforce the modest slowing of Chinese exports that was already in the cards -- largely an outgrowth of a softer global economy and the payback from a pre-booking of foreign shipments that occurred in the first half of 2005 in anticipation of the currency adjustment. The Chinese leadership will most likely adopt a “wait and see” stance insofar as further currency moves are concerned. If GDP keeps surging at 9.5%, then policymakers will probably push further on the currency-revaluation lever -- using the export trajectory as the cushion to engineer a soft landing. On balance, the shift in Chinese currency policy reinforces my conviction that a China slowdown is in the cards at some point in the next 6-12 months.
Thirdly, China’s new currency policy is a much more stable arrangement for the world financial system. From the Chinese perspective, it will help relieve the tensions that have been building from failed sterilization tactics -- the inability of China to issue enough domestic debt to offset the massive purchases of US Treasuries required by the now-abandoned dollar peg. This was leading to excess money and credit creation -- underscoring the mounting risks of inflation and/or asset bubbles. The coastal property bubble was a visible manifestation of this risk that China could no longer afford to ignore. A “managed float” provides China with much greater discretion on the sterilization front, thereby tempering the excesses of its domestic financial system.
This is also a plus for the rest of the world -- but with a potentially painful twist. By moving to a currency basket, China will need to diversify its enormous portfolio of foreign exchange reserves, which totalled some $660 billion at the end of 1Q05. Other Asian central banks -- also massively overweight dollars -- should follow China’s lead. The near-simultaneous announcement by Malaysia to abandon the Ringgit peg in favor of a managed basket float confirms such a possibility. Other central banks, such as the Bank of Korea, have been itching to diversify out of dollars.
Consequently, a more flexible RMB mechanism raises the odds of an Asian shift out of dollars, in effect removing the artificial bid for dollar-denominated assets that has provided a subsidy for US interest rates. This will undoubtedly put pressure on the interest rate support to US asset markets -- especially property. Asset-dependent American consumers will certainly be challenged by such a development. This could result in a reduced impetus from US consumption support -- in the end, the only real hope for a US current account adjustment. This is a plus for a long overdue global rebalancing but will be admittedly painful. Unfortunately, that’s probably the only way for the US and the rest of the world to come to grips with its most glaring excesses.
The financial market implications of this shift in Chinese currency policy cannot be minimized. At the most basic level, the FX reserve diversification play is likely to be negative for the dollar and bearish for US interest rates -- mirroring the classic trappings of a current-account adjustment. That, however, is not the only consideration bearing on the US interest rate outlook. The combination of persistently low inflation and a still-likely China slowdown remain important prospective developments on the bullish side of the interest rate equation. Over the near term, I suspect that the balance will now tip more toward the bearish outcome than I had previously thought. Over the medium term, however, I still believe that pressures on longer-term US interest rates will be contained by subdued inflationary expectations and the likelihood of a China-led shortfall in pan-Asian economic growth.
This was not an easy move for China. The nation’s leadership agonized long and hard over both the nature and the timing of an adjustment in its foreign exchange mechanism. External pressures from the US undoubtedly played an important role in underscoring the urgency for action. But in the end, it was China’s choice. The Chinese leadership has made a wise and prudent adjustment, in my view. The best news in all of this is that a flexible RMB is a big plus for global rebalancing. The peg was a major impediment to this process. By moving gingerly on the currency front, China minimizes the risk of overkill that a larger move might have triggered. There is nothing wrong with a China that goes slowly in feeling its way down the road to currency flexibility. This favors the gradual-adjustment scenario of global rebalancing. A large move could have tipped the scales toward the more disruptive option -- always a risk for a global economy with such massive imbalances. That could have led to a precipitous decline in the dollar, a spike in US interest rates, a collapse in the US property market, a severe adjustment by the American consumer, and a sharp global recession. The odds of such a hard landing in a US-centric global economy have been reduced by China’s shift in its currency policy.
Let’s give credit where credit is due -- always a hard thing for the world when it comes to China. My advice is to look at what now lies ahead: Do not focus on the 21 July action as the end, in and of itself. While this first move was small and belated, China’s currency adjustment is emblematic of an endgame that could be a linchpin to long overdue global rebalancing. This is awesome news for an all-too-precarious world.
News 
Market Data 
Discover 
AI
