Submitted by Qasim Khan
Markets have viewed China’s willingness to move to a more “market” determined value of CNY as an indication that Chinese officials believe the global economy is strong enough to weather a CNY revaluation. However, I contend just the opposite. What if China fears increased risk reversion as the worldwide economy slows down during the second half of the year? What if they are moving away from a peg to the USD because they are afraid that USD will appreciate significantly during an onset of risk aversion? Given the increasingly likely double dip scenario, China’s move toward a “market” based CNY value may ironically only exacerbate global imbalances.
In further proceeding with reform of the RMB exchange rate regime, continued emphasis would be placed to reflecting market supply and demand with reference to a basket of currencies. The exchange rate floating bands will remain the same as previously announced in the inter-bank foreign exchange market.
China’s external trade is steadily becoming more balanced. The ratio of current account surplus to GDP, after a notable reduction in 2009, has been declining since the beginning of 2010. With the BOP account moving closer to equilibrium, the basis for large-scale appreciation of the RMB exchange rate does not exist. The People’s Bank of China will further enable market to play a fundamental role in resource allocation, promote a more balanced BOP account, maintain the RMB exchange rate basically stable at an adaptive and equilibrium level, and achieve the macroeconomic and financial stability in China.
Much has been made of the PBOC’s recent decision to allow the CNY to “appreciate.” As I have argued since the announcement, it has become clearer that this “revaluation” was more pre-G-20 political posturing than an explicit declaration of a change in policy. However, as superfluous as the PboC’s statement was, its ambiguity may be more revealing than any change in policy could have been. Emphasizing a transition to a two-way, “market” price rather than identifying the particular aim of appreciation was a signal to skeptics like me that China had an ace up its sleeve. Market action has since corroborated such suspicions as the CNY has actually depreciated since Monday night’s fix and a recent WSJ report stated, “Traders on Tuesday said they saw signs that state-owned banks were buying dollars, in what was interpreted as a push at the behest of China’s central bank to push down the yuan’s value.”
Is it a shock then that they’re “de-pegging” now? Not really. China has never been one to succumb to international pressure, so clearly Chinese officials intrinsically believe the move to be in China’s best interests. In fact, given current economic uncertainty (sovereign debt crisis, drying up liquidity and stimulus effects, global austerity measures, etc),we may soon find that China’s de-pegging from USD is no concession on their part.
The crux of the thesis relies heavily upon slowing economic conditions, due in large part to the evaporating effects of fiscal stimulus and greater calls for fiscal austerity. Now it’s rather rare that I agree with Paul Krugman on anything, but as opposed as I am to deficit spending on such a massive scale, the fact of the matter is that deficits are there to be enacted countercyclically to help economies recover during periods of burden (not when economies are humming along, as has been done).
This situation is similar to airline companies, horrified by the movement in oil prices in 08, hedging their oil exposure at the height of the oil run up. The fact is these decisions are best made when they CAN be, not when they HAVE to be. Now is not the time for austerity; the time for austerity was before when we weren’t facing an economic downturn of extraordinary proportions. George Soros agreed with this belief earlier this week when he stated that the recent austerity measures in the Eurozone ensure a second recession in the near future.
The sovereign debt crisis presents a uniquely potent danger because it not only affects financial institutions with exposure like the ‘08 crisis, but the government backstops that essentially “resolved” the previous crisis as well. Given global financial interconnectedness and risks of contagion, its ramifications are not centrally concentrated as many would have you believe. This dilemma is not a Euro-specific issue; the US (especially on the muni level), UK and Japan are all going to address their imbalanced and unsustainable fiscal policies soon, as well.
Many market participants argue that the revaluation provides another outlet for tightening domestic conditions. However, what if instead of seeking another way to further tighten conditions, Chinese officials are worried they have tightened too much? Domestic tightening measures to control inflation have slowed growth and left the country increasingly vulnerable to potentially severe deterioration in global economic conditions. If USD appreciates against most currencies (all except JPY), as it tends to do during times of economic and financial distress, then perhaps this move was in all actuality protection against further CNY appreciation. The fact of the matter is this “flexibility” affords them greater economic control by creating a potential hedge against a flight to liquidity/safety (USD appreciation) that would accompany a worse than expected second half of the year. Rather than waiting for the downturn to manifest and attempting to revalue/devalue CNY, which would be exceedingly conspicuous and politically damning, they may have just jumped ahead and created protection in a much more opaque and politically convenient manner.
Ironically, if we do experience the dreaded double dip, the rest of the world may then realize that it CANNOT afford to let CNY appreciate given its absolute dependence upon their export driven model to fuel worldwide economic growth. Furthermore, resulting positive feedback could spell trouble for any hope of sustained global economic rebalancing. Specifically with respect to Sino-US relations, if global growth slows severely enough the US could potentially find itself begging for China to resume its export driven model to provide some source of economic growth for this world. This in turn would only spur more political tension, leading to greater protectionism and thus worsening global economic conditions. If anything, trade and economic imbalances would be further exacerbated, fueling the unsustainable yet another unsustainable force in the global economy.