china / us: the yuan and the dollar

CHINA/US: THE YUAN AND THE DOLLAR

G Stolwyk

Present situation: Japan holds about $US700 mill in US Bonds. As to China, it could have $US200 mill in US Bonds but they may have additional $US reserves. Some think this could be used as a weapon against the USA, ie by flooding the market with dollars and stopping taking US Bonds.

While strategically it is an advantage to have this, in practice, both countries don't want to see a US with a much lower dollar and high inflation as it would immediately affect their exports (40% of US imports come from China).

"Although we won't present all the data, when we aggregate all of the smaller countries (Hong Kong, Malaysia, etc.) who have either definitive or de facto dollar pegs, the number climbs higher to 45% of the total US trade deficit. (Contrary Investor, Febr.1, 2005).

Both China and Japan are good savers, so the advantage in trade is on their side

So, they will do al they can to keep the present relationship reasonably stable. Both convert much of their $US into US Bonds; this keeps the US Bond interest rates down and the massive US deficits financed up to a point.

Cheap Chinese exports keep inflation down and demand up in the US as well. (Overall, US inflation is increasing). Doing this lessens the US demands for trade protection.

From the Chinese point of view, they don't want a too high currency, because this would make their goods more expensive overseas and would particularly reduce the demand for goods from the US.

China also competes for exports with other Asian countries and a much higher Yuan or Rinembi would be to its disadvantage. But it will make imports into China cheaper and reduce inflation.

If the Yan were adjusted to realistic levels, then the Chinese may think of holding less devaluing US dollars and the previous cosy relationship with the US could become more strained, particularly if the approach from the US were too forceful.

The Chinese say that their Banking system is not up to scratch and they will be particularly worried about hot money from hedge funds entering the country. Hence there is no rush to revalue.

My opinon is that taking the positives and negatives into account, China will only *very gradually* revalue, the overriding factor being that a strong revaluation could induce the USA into a heavy recession and that is the last thing everyone wants, now there is a US slowing down already. Steady as she goes will be the Chinese motto.


So, what has the US to gain from a strong yuan revaluation? The goods from China will cost more and inflation will rise. If they left the Yan where it is and introduced VAT (GST) instead, that will also make the goods more expensive and also produce inflation but at least, they will have accumulated tax. Perhaps that wouldn't be acceptable from a political view as consumption is about 70% of GDP and the last thing to do is to induce a recession.

Their exports to China are not that great and will become less as outsourcing to China or other Asian countries continue, so there isn't much benefit there.

There are also a massive amount of US assets in China and this also needs to be taken into account: the more of these assets there are, the greater leverage, China has.

Many US Senators hasve been calling for a yuan revaluation for a long time without realizing the disadvantages. It has become a well worn slogan.

I think that a very gradual revaluation of the yuan will occur. That will still enable China to continue buying some US Bonds and so stabilize the dollar somewhat.

China will have to make its trading position much stronger (and reduce competing nations' manufacturing capabilities) before it can pay less attention to the USA.