China defends the Yuan
November 3, 2010

Vehemently addressing the currency issue with the US, a leading Chinese policy magazine Beijing Review recently ran a cover story stoking battle lines over why China was not going to play in favour of the US economy and why randomly releasing dollars and adopting zero-interest rate policies is gradually poisoning emerging economies. A week ahead of the G20 summit in Seoul, South Korea, on November 11-12, Inchin Closer brings you excerpts from the article below, to read the full article click here.

…Hoping to boost exports, the United States, EU and Japan announced successive rounds to quantitatively ease their monetary policies.

Emerging economies aren’t without problems of their own—concerns about inflation are rampant due to the economic rebound from the financial crisis. And as developed countries mostly adopt zero-interest rate policies, these measures are pushing emerging economies into a corner of appreciation. For instance, Brazil’s benchmark interest rate stands as high as 10.75 percent, causing the Brazilian real to appreciate more than 30 percent against the U.S. dollar, the fastest appreciating currency in the world.

Central banks in emerging economies like Brazil, India, South Korea, Thailand, Malaysia and Russia have interfered with the currency exchange markets out of fear of an export slump caused by the currency appreciation. The interference has not gone unnoticed, as developed countries are pointing fingers and accusing emerging economies of manipulating their currencies. Emerging economies in turn have argued developed countries are using loose monetary policies to trigger depreciation of their currencies.

The Beijing review continues by quoting Zhou Yu, an expert on international finance and currency at the Shanghai Academy of Social Sciences. While Zhou feels that the world is far from a currency war, measures of monetary easing by the west could trigger excess capital flows to the east which could result in another financial crisis in emerging markets – excerpts –

A currency war, Zhou said, would first increase the risk of inflation. If other countries blindly follow the U.S. method of quantitative easing, this “herd mentality” would trigger a rampant flow of liquidity. Judging from past experiences, the depreciation of the U.S. dollar will inevitably prop up the value of raw materials, crude oil and agricultural products, which will cause cost-driven inflation. In the second half of 2010, the U.S. dollar’s depreciation has led to a substantial increase of wheat, corn and cotton prices by 50 percent.

The inner stability of the international monetary system would also be shattered, Zhou said. The fluctuation of the U.S. dollar has a huge impact on international financial stability. At present, more than 60 percent of the reserved currencies of central banks around the world are in U.S. dollars, and 50 percent of international settlement is done using the U.S. currency. If the dollar depreciates dramatically, economies using the dollar as a settlement or reserve currency will face heavy pressures.

What’s worse, a currency war could escalate into a global trade war. As it stands, it will be nearly impossible for developed countries to increase their exports through currency depreciation as many emerging economies are interfering with the currency exchange markets. Under these circumstances, developed countries tend to adopt protectionist measures, such as threats of trade sanctions, to force emerging economies to appreciate their currencies.

No matter the cause, a currency war will increase the risks facing emerging economies. The U.S. monetary policies could lead to large capital inflows into emerging economies as the yields in emerging markets are much higher than those of developed countries. In turn, if those countries tolerate the dollar depreciation, their external trading conditions will take a beating. But if they interfere with their foreign exchange markets and prevent their currencies from appreciating, their inflation risk and capital bubble will throw their economies into a financial abyss. Once the U.S. Government raises interest rates, the large capital outflow will likely trigger a financial crisis in emerging markets.

The article continues to criticize currency calculations made by America – the United States adds the “Made-in-China” products it imports from other regions or countries to imports from China, while excluding its exports to China via Hong Kong or other regions, which contributes to the trade imbalance. Wang Yuanlong, an expert from the Hong Kong-based Tianda Institute further defends China’s trade imbalance with the US – The trade surplus is caused by differences in industrial division between the two countries. The service sector contributes about 80 percent to the U.S. GDP, with manufacturing making up only 11 percent. In China, the opposite is true, with manufacturing accounting for 60 percent of GDP. – when calculating its trade value with China, the United States only uses commodity trade data but excludes the value of services it exports to China.

Raising another significant point that most of the money raised in China was going back to American firms Yao Jian, spokesman of the Ministry of Commerce, defended his country’s stance. – The United States, Yao said, had a trade surplus for 93 years before the 1980s—China has only had a trade surplus for a little more than 10 years. More importantly, China’s surplus with the United States is mostly generated by foreign-funded or foreign-owned companies in China, which produce nearly 88 percent of Chinese exports to the United States. Those foreign investors have taken away the lion’s share of profits.

“If China held a surplus of US$10, US$1 or US$2 of it goes to China, but $7 or $8 goes to foreign-funded companies, mostly established by American, European and Japanese companies,” said Yao. “It’s utterly irrational [for the United States] to hold the yuan as the scapegoat for its own national problems,” he stressed.

Lastly, the article accuses the US, of forcing China to appreciate the yuan because America actually wants to depreciate the dollar due to high unemployment. – “The center of the conflict is that the United States wanted to depreciate the dollar, but was met with resistance from other economies. How things develop in the coming months depends on whether the United States changes its mind,” said Andy Xie Guozhong, an independent economist and a director at Rosetta Stone Advisors Ltd.

Right now, the belief among U.S. political leaders is that depreciating the dollar will help boost employment, Xie said. But this is just wishful thinking; the hovering unemployment rate is due to the fact that private companies are reluctant to hire new employees in these uncertain economic times.

“The only benefit of dollar depreciation is a slight increase in U.S. exports, but then inflation will come along. If other countries refuse dollar depreciation, and follow suit to print more money, worldwide inflation is inevitable,” said Xie. “Right now, it all depends on the United States,” he added.

So how will this currency conundrum wrap up? Its anybody’s guess say analysts, though going by the joint communiqué released at the G20 financial ministers and central bank governors’ meeting held in South Korea, a move toward more market-determined exchange rate systems that reflect underlying economic fundamentals and refrain from competitive devaluation of currencies is likely, with China agreeing to increase the flexibility of the exchange rate regime, but maintaining control over the pace of the yuan appreciation.

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