Friday, March 23, 2012

China wants a Divorce

China wants a Divorce


By: Elias Melad Osman (fxanalysis@akfinancials.net )


Intro


Over the years there has been an increasing amount of investors who believe China’s Renminbi (RMB) will eventually become a global reserve currency and thus challenge the dollar. This is not surprising of course when one observes an increasing momentum in China’s currency swap agreements with different nations. It is also not hard to see China’s attempt at moving away from the dependent relationship with the United States. But how is China going about it? What are the costs and benefits towards internationalization of the RMB? These questions among others are important to look at in order to have a better understanding the direction the RMB is taking and will likely take in the future.

In an ever so popular paper (Eichengreen, 2004) states that an influential school of thought views the current international monetary and financial system as Bretton Woods reborn. Today, like 40 years ago, the international system is composed of a core, which has the exorbitant privilege of issuing the currency used as international reserves, and a periphery, which is committed to export-led growth based on the maintenance of an undervalued exchange rate. In the 1960s, the core was the United States and the periphery was Europe and Japan. Now, with the spread of globalization, there is a new periphery, Asia, but the same old core, the United States, with the same tendency to live beyond its means. This view suggests that the current pattern of international settlements can be maintained indefinitely. The United States can continue running current account deficits because the emerging markets of Asia and Latin America are happy to accumulate dollars. There is no reason why the dollar must fall, since there is no need for balance of payments adjustment; in particular, the Asian countries will resist the appreciation of their currencies against the greenback. But are the Asian countries happy to accumulate U.S dollars? Can the U.S continue running a current account deficit? This common view presented in (Eichengreen, 2004) paper is now being questioned and this paper will also attempt to address this issue. Like (Eichengreen, 2004), I will attempt to show that this system is based on flaws. We start by looking at the intricate relationship between the United States and China and examine the policies China is pursuing. By doing so, we will shed some light on the marriage between the two nations and how China is being forced indirectly by the United States to move away from such dependency. More importantly we will examine how China is trying to move away from the United States by looking at SDR and the internationalization of the Renminbi (RMB)

China’s Currency policy—The RMB & USD

The US economy stayed at float until now due to the status the U.S dollar has as a global reserve currency. The ability to borrow an endless supply of money from China and other nations has sky rocketed the US debt over the years. The massive accumulation of debt has worried investors and foreign nations about the future value of the accumulated debt. For many years the United States has been able to convince the Chinese to rollover their maturing U.S treasuries plus interest into large amounts of new ones. At the same time the U.S has criticized the Chinese for keeping their currency artificially low, claiming this gives the Chinese an unfair advantage in the global markets. This contradiction has lead to some friction between the two nations and begs the first question: is the appreciation of the RMB a good thing for the United States and China? A complex question to answer as both sides can be argued but upon closer inspection, the appreciation of the RMB does have negative aspects for both nations. For China, if it appreciates its currency further it could cause further damage to the export sector and lead to more layoffs. For the United States, if China appreciates its currency further, it could slow China’s accumulation of foreign exchange reserves causing the reduction in the purchases of dollar assets, such as treasury securities, which in turn can cause friction to fund the Federal budget deficit. Therefore it is better to ask the question: Does appreciating the RMB benefit China more than the United States? To understand the matter better let’s take a closer look at the brief history of the exchange rate between the USD and RMB.

1994 until July 2005, China maintained a policy of pegging the RMB to the U.S. dollar at an exchange rate of roughly 8.28 Yuan to the dollar.

July 21, 2005 the Chinese government modified its currency policy. It announced that the RMB’s exchange rate would become “adjustable, based on market supply and demand with reference to exchange rate movements of currencies in a basket,” (Way, Morrison, & Labonte, 2011) and that the exchange rate of the U.S. dollar against the RMB would be adjusted from 8.28 Yuan to 8.11, an appreciation of 2.1%. Unlike a true floating exchange rate, the RMB would be allowed to fluctuate by up to 0.3% and later changed to 0.5% on a daily basis against the basket.

July 21, 2005 to July 21, 2008, the dollar-RMB exchange rate went from 8.11 to 6.83, an appreciation of 18.7% (see figure 1).

Mid-July 2008 China halted its currency appreciation policy mainly because of declining global demand for Chinese products that resulted from the effects of the global financial crisis. In 2009, Chinese exports and imports fell by 15.9% and 11.3% over 2008 levels. The Chinese government reported that thousands of export-oriented factories were shut down and that over 20 million migrant workers lost their jobs in 2009 because of the direct effects of the global economic slowdown. The RMB/dollar exchange rate was held relatively constant at 6.83 through around mid-June 2010 (Way, Morrison, & Labonte, 2011).

June 19, 2010, China’s central bank, the People’s Bank of China (PBC), stated that, based on current economic conditions, it had decided to “proceed further with reform of the RMB exchange rate regime and to enhance the RMB exchange rate flexibility.” It ruled out any large one-time revaluations, stating “it is important to avoid any sharp and massive fluctuations of the RMB exchange rate,” (Way, Morrison, & Labonte, 2011).




China & United States—Marriage doomed to fail


One thing can be clearly taken by looking at the history above and that is that China is resisting a fast appreciation of the RMB as much as it can. It also shows that appreciating the RMB can causes damage to the export sector. Resisting the appreciation of the RMB is understandable seeing how heavenly China’s growth is tied to its exports. In fact, the US trade deficit with China surged from $10 billion in 1990 to $273 billion in 2010 (Way, Morrison, & Labonte, 2011) and is projected to rise over the many years to come. Another interesting fact is the massive accumulation of foreign exchange reserves by China. It grew from $403 billion in 2003 to $3.2 trillion at the end of September 2011 (Way, Morrison, & Labonte, 2011). This dependency between the US and China is what complicates the matters further. With the U.S being China’s biggest export market and China being one of the biggest holders of U.S treasuries it is clearly a mutually beneficial relationship for both, as long as both nations abide by the rules. For the U.S this means good fiscal policies and a strong dollar, and for China, this means to continue investing in U.S treasuries and to keep the RMB relatively low and at stable levels. Therefore it is not in the interest of the Chinese or a benefit to them at this stage to appreciate their currency further.

Diving deeper into the marriage between the United States and China it is important to look at the vows or the rules both play by. It was noted above and it is worth repeating that the vow for the United States was a good fiscal policy and a stable dollar, whereas for China, the vow was to continue investing in U.S treasuries and to keep the RMB relatively low and stable. As long as both parties abide by the rules, the marriage between the two will flourish. In recent years, however, we have seen that the rules have changed. The U.S has been on a spending spree over the last decade and “helicopter Ben” has been dropping greenbacks like no tomorrow. It comes to no surprise than that the Chinese officials are beginning to worry about the future value of their U.S securities. If the U.S continues the path it is currently on with its fiscal policies, it will spark inflation (if not hyperinflation) in the United States and a depreciation of the dollar, which of course would negatively impact the value of China’s holdings of U.S securities. (Makes me wonder why we haven’t seen higher inflation rates thus far). At the same time, China cannot dump their US dollars or stop buying U.S debt because by doing so it could also cause the dollar to depreciate and thus reduce the value of its remaining holdings. This move would also have a devastating impact on the U.S economy. The Chinese understand this dilemma very well and in 2009, Zhou Xiaochuan called for replacing the U.S dollar as the international reserve currency with a new global system controlled by the IMF (Morrison & Labonte, 2009).

Enter SDR

On March 2009 Treasury Secretary Timothy Geithner briefly unsettled the currency markets when he appeared willing to entertain a Chinese proposal that an international currency supplant the U.S dollar as the premier global reserve currency (Phillips, 2009). Mr. Geither was of course revering to SDR or Special drawing rights. On the IMF websites we see that SDR is defined as “a form of money that the International Monetary Fund’s board of governors can create by crediting accounts of the Fund’s member states, at an exchange rate determined by a basket of major currencies.” The basket consists of EUROs, Yen, Sterling and the US dollar. There are limits on the SDR and specific rules on how a nation can use them. Replacing the U.S. dollar with SDRs as the new global reserve currency remains highly impracticable: creating and managing monetary policy on a global scale through the IMF would be a major challenge, yet without a system of global governance, SDRs will remain merely the sum of other currencies. Moreover, how will the IMF provide the level of liquidity required of a reserve currency? A reserve currency must be deliverable to central banks and other players who want to acquire it, which the United States does by running persistent trade deficits (Yu, 2010). On the other hand we cannot deny the fact that the SDR is a partial solution to the problem for both nations. If national currencies were converted into SDR, the threat of dollar devaluation to the value of foreign exchange reserves held by the rest of world, China in particular, would be reduced (Yu, 2010). This is the core issue the Chinese are currently facing, how do they get rid of all those dollars with limited losses? No simple solution exists thus far but in the near future the IMF might tackle the obstacles with SDR and it might be possible for China to get rid of their US holdings without incurring a huge loss. This doesn’t mean that China hasn’t taken other steps in reducing their U.S holdings. Looking at the data from the US Treasury Department, China's holdings of US Treasury bonds stood at $1.1326 trillion by the end of November 2011, $1.5 billion down from the previous month. It was the second successive month that the amount had declined, and the lowest reserve level seen since July 2010. China made six monthly cuts of US debt in 2011, the department's data showed, trimming its holdings by $27.5 billion from the end of 2010. Yet despite the reductions, China remains the top buyer of US Treasury securities (Campbell, 2012). This still doesn’t solve the dependent relationship China has with the U.S., so how is China going about that issue? The answer: The Internationalization of the RMB.

A closer look towards the internationalization of RMB: The Benefits & Costs


According to Kenen (2009), an international currency is one that is used and held beyond the borders of the issuing country, not merely for transactions with that country’s residents but also, and importantly, for transactions between non-residents. Some benefits for internationalization of the RMB are:

•More foreign trade and financial transactions would be settled in the RMB reducing the exchange rate risk for Chinese firms.

•Improve the funding efficiency of Chinese financial institution

•Enlarge bilateral trade and economic co operation

•It can help China preserve the value of its foreign exchange reserves. If China’s claims on the United States were denominated in the RMB, China would not need to worry about the possibility of suffering huge capital losses on its foreign exchange reserves as a result of the US government’s debasing of the US dollar (Yu, 2010).

The downside of internationalization

•The Chinese government is reluctant to give up capital control and this is the biggest obstacle towards a wholesale internationalization of the RMB. An M2/GDP ratio of 180% in China means that capital outflows may be huge if capital controls are dismantled. Without capital controls, the foreign exchange requirement would be very large and costly (Yu, 2010).

•China’s capital markets are still too shallow. Any significant changes in cross-border capital flows may easily lead to large fluctuations in China’s asset prices.

•China’s economic structure is still inflexible. Enterprises are slow to adjust to exchange rate and interest rate changes, and they need capital controls to provide them with breathing space. China’s financial institutions lack competitiveness and some protection is still needed (infant industry argument). All the above-mentioned arguments for capital controls can be used to argue against renminbi liberalization (Yu, 2010).

•Experience from the Asian financial crisis has shown that if a currency is fully internationalized, which means that it can easily be obtained in international financial markets; the country with an internationalized currency will be very vulnerable to speculative attacks from international speculators (Yu, 2010).

Looking at the costs and benefits of internationalizing the RMB we see that internationalizing the RMB does solve the dependency issue. By internationalizing their currency China can avoid accumulating future dollars in their reserves and thereby reducing the dependency on the United States. On the other hand, looking at the downside of internationalization we see that China is not ready at the moment to fully internationalize their currency. This explains why China is going about the matter in a delicate fashion and is taking its time doing so. Although not ready at this point, China is indeed in the process towards fully internationalizing their currency. An important aspect towards internationalizing the RMB is the act of creating bilateral currency swaps with different nations.


China’s bilateral currency swaps

Over the years China has signed many currency swap deals with their trade partners and a brief look at history shows that China has accelerated this process after 2008. Since the crisis in 2008, China has signed agreements for bilateral currency swaps with:

•Pakistan

•Argentina

•South Korea

•Indonesia

•New Zealand

•Hong Kong

•Japan

•Malaysia

•Belarus

•Thailand

•Turkey

•Uzbekistan

•Singapore

•Kazakhstan

•United Arab Emirates

So what? How does that affect the U.S dollar? The reader might ask. The currency swap is a bold move for China, in that it has the dual effect of both promoting Chinese exports to their trading partners, while also allowing this trade to be settled in Yuan rather than Dollars. China has slowly begun initiating a shift away from the USD while simultaneously increasing its economic presence in many unfamiliar regions. It marks yet another step towards full convertibility of the Yuan. While the swap shouldn’t incite outright panic, US policymakers need to recognize these coordinated actions in the broader context (Erdosfan, 2009). From the list above it is important to note that Japan and China are the world second and third largest economies with 26.5 trillion Yen ($340 Billion) in transactions in 2009 between the two.

Conclusion

We have seen how China has been moving away from the dependent relationship with the United States. Simply put, China wants a divorce. Through reducing their current U.S. holdings and steps taking towards internationalizing their currency, China is already on its way in securing a more stable future for the RMB. The US dollar has been dominating the world as a reserve currency for a long time. The euro entered the global financial system in the last decade or so and already succeeded in becoming a competitor to the dollar. The Asian financial crisis and the crisis of 2008 showed the world how fragile the global financial system really is. It comes as no surprise than to observe nation states seeking risk aversion and the avoidance of another global crisis. This path towards diversification and risk reduction is observed by China’s move to get away from the dollar with the internationalization of the RMB. A greater use of the RMB will be a balancing factor in global stability. As a matter of fact, what many investors don’t know is that similar steps are being taken across different regions in the world. With “helicopter Ben” dropping green backs with its Quantitative Easing program, many countries around the world are seeking ways to escape a hostage situation with the U.S dollar.

“The Latin Americans established the Bank of the South and are slowly laying the groundwork for a new currency, the SUCRE. As in Asia, the Bank of the South will be one of the fundamental institutions of the Union of South American Nations that has been launched in Latin America in order to guarantee the independence of the societies of Latin America. Not to be left as the only region holding dollars, the leaders of the oil rich states of the Gulf Cooperation Council have been buying gold while announcing as long ago as 2009 the intention to establish a monetary union with a common currency. In Africa there are plans for the strengthening of the financial basis of the African Union but so far there has not been the same kind of coordinated regional plans for financial independence. During the period of the debate on the debt crisis in the USA, the Nigerian central bank governor Lamido Sanusi announced that Nigeria plans to invest 5 to 10 percent of its foreign exchange reserves in the Chinese currency - the Yuan also known as the renminbi (RMB)” (Campbell, 2012). The world today is not the same as it was in the 1960’s and countries in Latin America and Asia are no longer happy to accumulate dollars. Bretton woods is not reborn. This is seen with China’s attempt to move away from the dollar and similar signs are cropping up across different continents. This also means that the United States can no longer continue running current account deficits because countries are beginning to question the future value of the dollar. If the United States continues running deficits it will only accelerate the process of internationalizing the RMB and other currencies.

Perhaps the future of currency trading will look much different with continental currencies rather than currencies of individual countries. This will be a good way of reducing the risks of a future crisis. This will also allow countries to move away from being dependent on the U.S dollar. The U.S dollar has much evidence piling up against its future and the worries investors face is not unfounded. So now the question becomes: How will the dollar go? Will it be a gradual decline of its value that will force the U.S to re-evaluate the exchange rate of the dollar against other currencies? Or will it go the hard way where investors will panic and the dollar will experience a major sell off? Perhaps “Helicopter Ben” will stop its spending spree and U.S policy makers will adapt better fiscal policies and heal the cracks of the fragile system. At the end only time will tell but what we do know is that the path the U.S is currently on is detrimental to the dollar.




Works Cited

Campbell, H. (2012, January 23). China and Japan Currency swap- A nail in the coffin of the U.S. Dollar. Retrieved March 15, 2012, from Buziness Africa: http://buzinessafrica.com/index.php?option=com_content&view=article&id=724%3Achina-and-japancurrency-swap-a-nail-in-the-coffin-of-the-us-dollar&catid=18%3Aexperts-policycenter&Itemid=20⟨=en

Eichengreen, B. (2004). GLOBAL IMBALANCES AND THE LESSONS OF BRETTON WOODS. Cambridge: NATIONAL BUREAU OF ECONOMIC RESEARCH.

Erdosfan. (2009, April 17). The Real Implications of China's Currency Policy. Retrieved March 15, 2012, from Shadow Bankers: http://shadowbankers.wordpress.com/2009/04/17/the-real-implications-ofchinas-currency-policy/
Morrison, W. M., & Labonte, M. (2009). China's currency: A Summary of the Economic Issues. Congressional Research Service.

Murphy, M., & Yuan, W. J. (2009). Is China Ready to Challenge the Dollar? Center for Strategic & International Studies.

Phillips, M. M. (2009, March 26). Geithner's Gaffe briefly hits dollar. Retrieved March 12, 2012, from THE WALL STREET JOURNAL: http://online.wsj.com/article/SB123798757974938125.html

Way, Morrison, W. M., & Labonte, M. (2011). China's Currency Policy: An analysis of the Economic Issues. Congressional Research Service.

Yu, H. G. (2010). Internationalisation of the Renminbi.












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