Michael Collins explains why Beijing is experiencing restless nights about the rising yuan.
Former US president George W Bush, in his autobiography Decision Points, recounts how he asked his Chinese counterpart Hu Jintao what kept him awake at night. The answer?
Creating 25 million jobs a year.
The remark reveals much about the mentality of China’s rulers.
It reinforces the view that anyone who wants to forecast the yuan’s value would do better to ask a political analyst rather than an economist.
An economist, though, could explain the fundamentals driving the yuan, which is controlled by the government (even if the peg to the US was ended in June last year).
The biggest fundamental force on the yuan is China’s export performance since the government in 1978 began a two-pronged economic rebirth, one part of which was called ‘opening up’ or easing China back into the world.
In the past decade alone, China’s exports have grown about 19 per cent a year, enough for China to overtake Germany as the world’s biggest exporter in 2009, when it shipped products worth US$1.2 trillion.
Importantly for China’s currency, exports far exceed imports – the country’s trade surplus for 2010 was US$183 billion.
The result is that since the mid-1990s China has run sizeable current-account surpluses, which averaged 6.8 per cent of GDP each year from 2003 to 2010. Textbook economics tells how a current-account surplus puts upward pressure on a currency because demand to buy the currency exceeds orders to sell.
Other fundamental forces driving currencies are inflation rates in relation to those of trading partners, and capital inflows. Inflation, for the most part, would have a neutral or even downward pressure on the yuan, because China’s inflation rate (now at 5 per cent) often exceeds those of its trading partners.
But capital inflows counteract this – especially foreign investment flows.
The country attracted US$473 billion of foreign (direct) investment from 1980 to 2010.
The economic cost
The upward pressure on the yuan from China’s current-account surplus and capital inflows means that China’s government has sold yuan/bought US dollars to maintain the various pegs or currency bands (explicit or otherwise) under which the yuan has operated since China opened its economy.
These foreign-exchange purchases have resulted in China amassing the world’s largest pile of foreign reserves, totalling US$3.04 trillion as at 31 March 2011.
From the economist’s point of view, the cost of this policy on China is clear.
An undervalued yuan adds to inflationary pressures in China because imports are more expensive than otherwise, and the government is adding to the supply of yuan within the economy when it purchases foreign exchange to control the US-yuan rate.
This higher inflation within China eventually erodes the cost advantage a lower yuan gives exporters.
The World Bank estimates that inflation has contributed to an average 5.5 per cent annual increase in China’s trade-weighted, effective real exchange rate from 2005 to 2010.
Another cost is that it lowers living standards for China’s population, because China’s leaders, in effect, are offering the world’s shoppers bargains at the cost of their own consumers. Another cost of the low yuan policy is that China is squandering its resources.
Money has been spent on buying low-yielding US Treasuries rather than invested in more profitable ways or spent on social goods (infrastructure or hospitals) that would boost the welfare of the population.
Lastly, the low-yuan policy causes friction with other countries, especially the US. If these get out of control, the potential cost is huge.
The political calculation
Yet China still persists with its low-yuan policy. Why? Here’s where the political analysis comes in. First, a low yuan is good for many politically influential Chinese companies that export.
The second reason is exposed by Hu’s comment.
In China, authorities worry about “social stability” – that is, keeping their subjects happy enough to leave them in power – especially now following the unrest in north Africa and the Middle East since December.
Authorities realise that Communist ideology is spent and nationalism and Western materialism have for the main replaced it as the glue to keep China together.
They believe they can keep China’s population contented through economic progress, rising living standards, a wider social-security net, reduced inequalities across the country and full employment.
Their goal is to avoid any shocks to the Chinese economy.
Given the role that exports have played in China’s ascension, authorities seem to fear that a jump in the yuan will cripple exporters and add to the official unemployment rate of 4.2 per cent – though the unofficial estimate is that about 10 per cent of China’s 800-million-strong workforce is jobless.
Given these concerns, it appears the political calculation of China’s rulers is to pursue incremental currency reform while attempting to boost domestic consumption.
China’s policies to bolster consumer spending include more social-security spending on health and unemployment, a national public superannuation scheme, tax cuts or income support for rural dwellers and policies to encourage jobs in service industries such as retailing, domestic tourism and transport.
These will all take time to boost consumption from about 35 per cent of gross domestic product to a more Western-like 70 per cent of output. But a disgruntled population can quickly cause trouble. No wonder Hu is restless at night.
Michael Collins is an investment commentator at Fidelity.
