China's Revaluation-One Year Later

July 23, 2006 2:53 PM by Stefan Karlsson | Other posts by Stefan Karlsson | Comments (6)

This weekend marks the one year anniversary of China's first step away from its more than decade old peg to the U.S. dollar. This meant a small 2.1% revaluation from 8.28 to 8.11 versus the dollar, as well as -they claimed- a move from a pure dollar peg towards a peg to a currency basket, consisting -they claimed- of the U.S. dollar, the euro, the yen, the U.K. pound, the Russian rouble, the South Korean won and the Thai bath.

It is now evident that their claims to follow a currency basket was a lie. The yuan's movements have at many times moved in ways which are inconsistent with how it would have moved under a currency basket consisting of the above mentioned currencies, regardless of the weight.

Instead, the yuan have moved very slowly upwards. The latest exchange rate (July 21, 2006) being 7.9897, representing a 1.5% appreciation.

While this timid strategy have so far been largely successfull in the sense that it has prevented China from being formally branded a "currency manipulator" and protectionist legislation of the draconian form once proposed by Senators Charles Schumer of New York and Lindsey Graham of South Carolina, it is clearly unsustainable.

In order to prevent the yuan from rising more than the very slow 1.5% increase we have seen during the latest year, the People's Bank of China have been forced to intervene massively and increase its foreign exchange reserves by an incredible $230 billion (From $711 billion to $941 billion). In just a few months, it will likely surpass $1 trillion, a clearly excessive level.

This massive build-up of reserves makes the efforts of the Chinese authorities to contain inflationary excesses by raising interest rates , raising reserve requirements and implementing various administrative controls on bank lending ultimately doomed to fail. In order for a monetary policy tightening to be effective. the build up of reserves must be contained and that requires a significant yuan revaluation. And as these reserves are usually in low-yielding assets nominated in currencies ultimately doomed to fall in value versus the yuan, this means that the hard-earned savings is squandered.

In this context see also this discussion between Nouriel Roubini and David Altig, where particularly Roubini makes many good points.