Last week ended rather quietly on world markets although there was quickly a statement of significance from the Chinese Central Bank. For those who do not follow the situation closely it has been considered for a while internationally and by the US administration that the Chinese Yuan is undervalued (estimates vary between 25 and 40%) and that this is one of the reasons for China’s Balance of Payments surplus and a contributor to the American deficit. The fact that the Chinese Yuan has been pegged to the US $ at an exchange rate of 6.83 Yuan to the dollar has only reinforced the importance of the issue to the United States. Late on Friday the Chinese Peoples Bank of China put a statement on its website from which I which quote below.
In view of the recent economic situation and financial market developments at home and abroad, and the balance of payments (BOP) situation in China, the People´s Bank of China has decided to proceed further with reform of the renminbi (Yuan) exchange rate regime and to enhance the renminbi (Yuan) exchange rate flexibility.
The global economy is gradually recovering. The recovery and upturn of the Chinese economy has become more solid with the enhanced economic stability. It is desirable to proceed further with reform of the renminbi exchange rate regime and increase the renminbi (Yuan) exchange rate flexibility.
In further proceeding with reform of the renminbi (Yuan) exchange rate regime, continued emphasis would be placed to reflecting market supply and demand with reference to a basket of currencies.
China’s external trade is steadily becoming more balanced. The ratio of current account surplus to Gross Domestic Product, after a notable reduction in 2009, has been declining since the beginning of 2010. With the Balance Of Payments account moving closer to equilibrium, the basis for large-scale appreciation of the renminbi (Yuan) exchange rate does not exist.
What does this mean?
This means that we can now expect the Chinese currency to begin to appreciate gradually over the next weeks and days. I would not expect any great move in the short term as the last paragraph I quote is quite explicit on this front. The daily trading range for the Yuan mentioned above is 0.5% of its value and one can now expect it to drift upwards within such ranges. I think that today the People’s Bank of China has reinforced my view on its strategy by announcing that todays trading range will be centred on an exchange rate of 6.8275 to the US $. When the currency was last allowed to rise back in 2005 then it rose by 21% over 3 years until the peg to the US $ was reinstated in July 2008 but I expect China to resist moves on any such scale by currency intervention (although my recent article on the Swiss experience does suggest that there are limits to such a policy, China does have the advantage of being much more powerful in terms of size of her economy). The initial move has taken the Yuan from 6.83 to 6.802 against the US $ so quite a small move in the circumstances.
One can see from the statement saying that her Balance of Payments is moving back to equilibrium that China does not entirely share the view held in the United States and internationally that she has used her exchange rate as a weapon to increase her level of exports and reduce her imports. However perhaps the fact that Chinese exports rose by 48.5% in May helped to increase pressure on China. This meant that exports exceeded imports by $19.5 billion in May up from a $1.68 billion surplus in April and a deficit of $7.24 billion in March 2010.
The Impact of this for China and the world
As the Yuan appreciates one might hope that China’s balance of payments surplus will reduce. As it is one of the imbalances in the world that economists have described as a feature and indeed cause of current economic problems then this in itself will be a positive for the world economy. One would hope that the so-called “debtor” nations such as the US and UK might benefit. Unfortunately for us in the UK our volume of trade with China in terms of exports is low so we may only see quite small gains if at all. World equity markets have certainly taken this on board with Asian markets rising strongly and the UK FTSE 100 rising by 1.5% in early trade.
It is easy to forget that against a large trading partner the Chinese Yuan or renminbi had been appreciating over the last 6 months or so and by approximately 16% over the period. As it is pegged against the US dollar then China’s currency had been appreciating against the Euro, this is the flipside of the Euro’s recent fall. So in terms of world trade there had been exchange rate moves affecting China for a while. It remains to be seen how much she is willing to allow her exchange rate to appreciate on a more general basis and how much impact it will have for the world. Not for the first time the world will be wondering if China means what she says.
US Treasury Bonds
One of the features of the recent period has been the extraordinary size of the purchases of US Treasury Bonds made by China. This has been a function of her trade surpluses in that the money has to go somewhere and as such surpluses have been enormous then they lead a large market to go to. Of course with her large deficits and accordingly large issuance of government debt then the US Treasury Bond market is not only very large but getting larger. Thus China has become almost a “purchaser of last resort” for US government debt. I am cautious of many of the figures that are produced on this subject simply because in the past such numbers have proved unreliable (recently it looked like the UK was a large purchaser of US government debt for example which turned out to be China buying through the UK). However there is no doubt that China has purchased very large amounts of US government debt in recent years (so much that if she stopped many question America’s ability to finance herself). One clue to the size is that China’s foreign currency reserves total some US $ 2.7 trillion but of course this is a total not an investment breakdown. With the recent rally in the price of US Treasury Bonds then these investments are likely to be doing very nicely, although China could never sell them in one go.
Think now of the impact of a currency appreciation. All of the US Treasury Bonds that China has purchased will fall in value as measured in her own currency the Yuan as it appreciates, as they are priced in a depreciating (falling) US $. So this is another reason for China to keep the appreciation on a slow and gradual trend.
On this subject there has been a concerning trend in the US Treasury Bond market recently. Over the past couple of months the US Treasury has not been issuing as many bonds as you might have expected. It has been true for some time that the US Treasury has followed what bond watches like me call a risky strategy as in it borrows short. The average length of the bonds that it has issued to finance the debts of the United States is between 4 and 5 years which is quite short compared to her international peers. This is currently shortening as the US Treasury underfinances maturing bonds which come up.
Now this move is seductive in the short-term as if you look at short -term rates it is very cheap to do so. The danger is that if you end up borrowing on a short-dated basis any economic shock immediately becomes a big problem as you have reduced your flexibility to deal with it. You simply have to roll debts over even if you would prefer not too. Greece has been an example of how this can be a problem over the past 6 months or so although she in fact has a longer average maturity than the US. So the American policy may well save money for now but as her debts increase it becomes in my view an increasingly risky policy.
If you look at the cost of borrowing longer-term for the United States it is in fact very cheap in my view. I know that it will cost more than using 6 or 12 month Treasury Bills but a yield of 3.23% for ten-year paper represents an opportunity to my mind. Just to put this into perspective the yield a year ago was 3.83% andtwo years ago it was 4.15%.
The gain for the United States Treasury is that the current policy is cheap. However cheap is not always good as in this subject when you are a large borrower emphasising short -term gains is at best unwise and may turn out to be foolish. In other words it is another moral hazard where things look good for now ( it helps the US fiscal deficit) but potential problems are not only deferred but increased in size. I believe the current phrase for such behaviour is “kicking the can down the road”.
Dissension at the G20
At the end of this week the G20 group of nations will meet. There will be some satisfaction at the statement discussed above made by China which if it blooms into reality will help world trade imbalances. However we then run into a subject which is likely to see some if not a lot of dissension. For example President Obama said on Friday.
“We must be flexible in adjusting the pace of consolidation and learn from the consequential mistakes of the past when stimulus was too quickly withdrawn,”
So he is worried about parallels with the 1930s and perhaps has concerns about recent economic figures in the United States.
Now lets us look at Europe. Germany has announced a fiscal austerity programme estimated at 80 billion Euros over the next few years, Spain and Portugal have recently announced a further tightening, the UK has an emergency budget tomorrow which will involve some considerable fiscal tightening if her new government is to be believed. Spain and Portugal announced further fiscal tightening a month ago. A French official has announced that she intends to save some 100 billion Euros over the next few years as she begins her austerity programme. Even Italy has joined in as her government recently approved a 24 billion Euro austerity package aimed at reducing the national budget deficit – which last year was 5.3% of its gross domestic product – to within the euro-zone limit of 3% by 2012. Greece has the most severe austerity package of all.
I hope that you get my point. Europe is travelling in exactly the opposite direction to that called for by President Obama. It would appear that just as there is hope for one problem we may run into another!
On this subject I intend to look at several issues and wish to raise some subjects for debate as follows.
On an individual basis austerity for many countries is a potential way out for their problems, however with some many in Europe attempting to apply it at once are they in danger of sucking each other downwards in a deflationary spiral?
Did the (Keynesian) fiscal stimulus policies applied to the “credit-crunch” inevitably lead to the austerity hangover and was it therefore yet another example of “kicking the can down the road”?