What country has been criticized for undervaluing its currency?

By Simon Rabinovitch, Kevin Yao

BEIJING (Reuters) - Much as critics of China’s currency policy would like to pin the blame for the country’s bout of inflation on an undervalued currency, the truth is that a cheap yuan is just one cause of rising prices and certainly not the trigger.

The corollary may be even more unsettling for them. Without much appreciation, Beijing should be able to wrestle prices under control.

“This round of inflation is a monetary phenomenon. The root is loose money. Yuan appreciation may play a part in the loose money, but I don’t think it is the key reason,” said Dongming Xie, China economist at OCBC Bank.

“In China’s case, the impact of currency appreciation on the consumer price index is not as big as in small economies.”

Economists are brought up on the idea that a country with an undervalued exchange rate for a prolonged period of time will eventually experience inflation.

According to this line of reasoning, price pressures bubbling up now in China are simply a result of the government’s long-standing unwillingness to let the yuan rise more quickly.

On a fundamental level, a cheap yuan has led to an accumulation of cash in the Chinese economy, providing ample kindling for a flare-up in inflation -- a view expressed last week by U.S. Treasury Secretary Timothy Geithner.

But from a short-term perspective, the current jump in prices has little direct connection to the exchange rate. And in the short term, at least, yuan appreciation will be only a small part of the government’s solution.

The last five years have proven that China is capable of defying economic gravity.

The swelling of its foreign exchange reserves, from $819 billion in 2005 to $2.65 trillion at last count, would have generated inflation or currency appreciation in most countries.

But in China, inflation has averaged only about 3 percent per year since then, while the yuan has gained just 7.4 percent on a trade-weighted basis, according to the Bank for International Settlements.

END OF THE LINE?

The explanation of Beijing’s gravity-defying success is that it has broken the circuit between currency undervaluation and inflation. Empowered by both its size and its many levers of control in the financial system, it has been remarkably successful at sterilizing foreign exchange inflows.

China has sopped up cash with a steady issuance of central bank paper, locked up more liquidity through reserve requirements and kept a tight grip on credit growth by giving banks strict orders about how much they can lend.

Could it be that the sudden jump in inflation to a 25-month high means that China’s charmed run is coming to an end?

“Five years of massive current account surpluses will always bring inflation at some point,” said Stephen Green, an economist with Standard Chartered in Shanghai. “Yuan undervaluation is certainly one of the key causes of the liquidity conditions we have.”

But he is also quick to point out other factors, from higher wage costs to the cyclical impact of a surge in bank lending.

Having been careful for years to keep excess cash out of the economy, Beijing opened the sluice gates to counter the global financial crisis. It has been too slow to close them.

The People’s Bank of China noted in a report last month that money growth was still too fast, a lagging effect from last year’s record 9.6 trillion yuan in new loans.

GET THE MONEY OUT!

The problem, in other words, is not a sudden inability to manage liquidity, but a temporary suspension of liquidity-management discipline.

There are signs that Beijing is intent to get it right again. Along with raising reserve requirements to a record high for big banks at 18.5 percent, there is also talk that it will cut total lending quotas by about 15 percent next year.

Nevertheless, while China has done well to cope with all the cash that has streamed in over the years, this cannot continue forever. It has to find ways to guide some of the money to the exits, said Zhou Qiren, an academic adviser to the central bank.

“The real solution to this problem is to encourage Chinese people to spend money overseas and domestic enterprises to venture abroad,” Zhou, who is also a professor at Peking University, said in remarks that were published on Thursday.

A stronger yuan would help in that respect by making imports cheaper for Chinese shoppers and by giving Chinese firms more purchasing -- and investment -- power abroad.

So along with interest rate increases, higher reserve requirements, tighter lending controls and even price intervention, faster yuan appreciation is sure to be on the policy menu for Beijing in its fight against inflation.

Importantly, a stronger yuan would help curb imported inflation, a priority as global commodity prices edge up on the back of monetary easing in the United States.

“Lack of yuan appreciation exacerbates the external shock from commodity prices,” said Andy Ji, economist and currency strategist at Commonwealth Bank of Australia in Singapore.

But if the past is any guide -- and in China, it certainly is -- the yuan’s rise will be gradual.

“Going too fast would encourage even more capital inflows, pushing up prices further,” said Tan Ruyong, a professor with the Shanghai University of Finance and Economics.

Stanford economists Michael Spence and Nicholas Hope are carefully watching China’s currency devaluation and its effect on the American and international economies.

China’s surprise devaluation of its currency this week will likely boost the country’s exports and generate more jobs at home, Stanford scholars say.

Since Tuesday, China’s currency has fallen 4.4 percent, sparking concern among the numerous countries intertwined with the world’s second largest economy. There is more to the story, according to China experts at Stanford.

A. Michael Spence, a Stanford economist who has studied China, said that China’s currency devaluation indicates it is struggling to meet its 7 percent economic growth target for this year and that domestic growth engines are not working fast enough.  

“In addition, the devaluation relative to the U.S. dollar probably reflects the strength of the dollar. The picture would look different relative to the euro and yen. The (Chinese) stock market volatility did not help this year,” said Spence, professor and dean emeritus of the Graduate School of Business at Stanford. In 2001, he was awarded the Nobel Memorial Prize in Economic Sciences for his contributions to the analysis of markets with asymmetric information.

As for why China is devaluing its currency, Spence said that Chinese officials are trying to increase exports by making Chinese goods cheaper. Chinese exports fell 8 percent last month compared with a year ago.

Spence advises that China should use its considerable assets to accelerate reforms and long-term growth-oriented investments as it grapples with a slowing economy.

It is a delicate economic time for China, as Spence and other experts say the country could be caught in a “middle-income trap” – a common danger for developing economies when they begin to lose their competitive edge in exporting manufactured goods because their wages are on a rising trend.

“To simplify, the middle income transition requires a major shift in the growth dynamics and supportive policies. Many countries do not make this shift. It can be thought of as sticking with a successful formula beyond its useful life,” said Spence, also a senior fellow at Stanford’s Hoover Institution.

Critics have said China manipulates its currency to gain a trade advantage. Some U.S. policymakers have long argued that the renminbi is undervalued and that this has influenced many American companies to move production to China.

Stanford economist Nicholas Hope said the devaluation – though it received widespread news coverage – is such a small one that its impact is more symbolic than substantive.

“The chief effect of the Chinese move is to serve notice that China really is managing its exchange rate on a basket of currencies rather than a loose dollar peg,” said Hope, director of the China Program for the Stanford Center for International Development, which is part of the Stanford Institute for Economic Policy Research.

Hope said several factors could have contributed to the sudden adjustment of the fixing point of China’s currency to the U.S. dollar.

“First, for some months the rate has languished at the weak end of the range around the old 6.1162 fixing (of the currency), and the adjustment recognizes what the market has been telling the Chinese authorities,” he noted.

Second, after a lengthy period of stability at around 6.21 renminbi yuan to the dollar, China might be reminding market participants (along with the International Monetary Fund) that the Chinese currency floats, even if it is not freely flexible, according to Hope.

Third, after announcing a decline in international reserves for a third consecutive month, China might be discouraging speculative capital outflow by a small pre-emptive weakening of the currency, he said.

“Finally, given that export performance has disappointed, and even though the current account remains in surplus, the move is in the direction of maintaining China’s international competitiveness,” Hope said.

Hope suggested that China would be better off if it accelerated structural reforms that contribute to greater efficiency of investment and higher productivity. “Appropriate policies to boost domestic demand could help as well,” he added.

Overall, he believes the impact of the devaluation will be minimal.

“To the extent that others are affected, those countries that compete with China for sales to the European Union and the U.S. markets are likely to experience the biggest impact,” Hope said.