July 29, 2005

There is less here than meets the eye -- unless there is more. That’s the considered reaction of the experts to the recent decision of the Chinese authorities to allow the renminbi to increase in value by 2.1% and fluctuate 0.3% daily, and to switch from a dollar yardstick to a basket of currencies.

There seems to be general agreement that the revaluation will not do much to reduce our trade deficit with China. Some Chinese manufacturers will absorb the increased costliness of their currency by lowering margins rather than by raising prices. Others, especially manufacturers of electronic products, are raising prices a bit, according to importers with whom I have spoken. To the extent that those price increases make Chinese companies marginally less competitive, the business they lose will go to other Asian producers, rather than trigger a revival in America’s electronic, apparel and other import-devastated industries.

Nor will the change in China’s policy have an immediate impact on interest rates in the US. With the Federal Reserve Board’s monetary authorities committed to continue rate increases before the currency revaluation, the economy so strong that “boom” is replacing “Goldilocks economy” as the most-used descriptive, and the vast majority of companies reporting robust profits, interest rates are headed up. Nothing the Chinese do, short of suicidally dumping their vast holdings of dollars, can affect that trend significantly.

Whether there is more or less here than meets the eye will depend less on what the Chinese have done than on what they do next. Treasury Secretary John Snow hailed the Chinese for moving to market-based exchange rates. Which, of course, they have explicitly refused to do -- to the applause of Joseph Stigler and other economists who say that stability of the renminbi is important to China’s ability to continue its rapid (9.5% annual) economic growth, and to the prosperity of the Asia-Pacific region.

The Chinese have been their usual inscrutable selves. Zhou Xiaochuan, governor of the People’s Bank of China (PBOC), characterized the revaluation as an “initial adjustment”, suggesting there is more of the same in our future. When speculators scented their favorite path -- a one-way street, with the value of the renminbi headed relentlessly up, it seemed that a wave of hot capital would swamp the Chinese authorities’ ability to cope with its inflationary consequences.

Just as the currency speculators were getting ready for a saunter down that one-way street, the PBOC in a “solemn declaration” declared, “This certainly does not mean that the 2 percent readjustment of the renminbi is a first step that will be followed by further adjustments.”

The markets seem to be deciding that the solemnity of the declaration is questionable. Fourteen leading foreign-exchange dealers, surveyed by Dow Jones Newswires for The Wall Street Journal, are expecting a further upward revaluation of 6%, bringing the total increase in the value of the renminbi against the dollar to a bit more than 8%. At this writing, trading in one-year contracts shows that the market is predicting a further 4.6% revaluation, bringing the total to 6.7%.

 

      Both figures fall short of what Washington’s politicians are telling the Chinese they must do to defuse pressure for protectionist measures. The Treasury initially said that it was hoping for a 10% revaluation, but then retreated in fear of offending the Chinese, a fear that seems to dominate the administration’s China policy, at least in the area of finance. China’s leading critic in congress, Senator Chuck Schumer, says he expects further (unspecified) revaluations, and will be “carefully monitoring this process over the next few months.” Some economists are telling him that it will take a revaluation of 40% to have a significant effect on America’s trade deficit. That is not in the cards.

My own guess is that no revaluation that is acceptable to the Chinese will cool the rhetoric of its critics. For the next few months Schumer and colleagues will be absorbed with their fight to prevent President Bush’s Supreme Court nominee, John Roberts, from being confirmed by the Senate -- at least not without a reputation-damaging fight. After that, continued massive trade deficits will again attract the attention of the protectionists, who will find allies among conservative Republicans who worry about Chinese threats to Taiwan, its one-child-only abortion-inducing policy, its efforts to lock up oil supplies, and its stated intention of replacing the US as the dominant military/economic power in the Asia-Pacific region.

Meanwhile, fears that the revaluation would prompt Asia’s central banks to dump their vast hoard of dollars have not materialized. Most of these banks had already diversified their currency holdings about as much as they consider prudent even before China’s revaluation.

Nor have fears of a negative impact on US share prices proved well-founded. Many analysts feared that the Chinese move would trigger a spurt in interest rates, with devastating effect on the interest-rate-sensitive capital goods and housing industries, and on share prices. In the event, orders for capital goods are rising, new home sales have hit another record, and stock markets have shrugged. All in all, says the Fed in it is latest report, economic activity in all twelve Federal Reserve Districts “continued to expand in June and early July... [and] labor markets generally continued to improve.” It is early days yet, but it seems unlikely that the minor change in the value of the renminbi will abort that expansion.

That misfortune is more likely to come from major policy errors, such as an inability to get the structural federal deficit under control. A profligate congress is handing an even more spendthrift president an energy bill laden with goodies for everyone from corn growers -- mandates for more ethanol in gasoline -- to the nuclear industry. The fact that nothing in the bill will reduce oil imports is irrelevant to politicians eager to please their various constituencies. 

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A version of this Update appeared in The Sunday Times (London)