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China – stuck between a rock and a hard place

For many years now China and the US have been playing a dangerous game – with short term advantages to both nations, but long term risks – as the fundamental imbalances between the nations have grown, to a point where they now seem unsustainable, leaving both countries with choices between a selection of unpalatable alternatives.

The game has been chronic undervaluation of the renmimbi. From 1997 to 2005, the renminbi was kept at a fixed rate of 8.27 yuan per US dollar, but since July 2005 the currency has been fixed in a narrow band (currently 0.5%) around a rate announced by the People’s Bank of China, fixed with reference to a basket of world currencies.  This did allow the renmimbi to rise more than 20% against the dollar from mid 2005 to late 2008, but with the onset of the global financial crisis, Beijing halted the currency’s gradual rise until June 2010, since when it has once more allowed a gradual appreciation.

The artificially high competitiveness of Chinese goods has allowed it to achieve the largest current account surplus in the world ($272.5 billion in 2010) whilst the US runs a huge current account deficit ($561 billion in 2010). China also runs a capital account surplus, as a result of which it now has the largest foreign reserves in the world, reported at $3,200 billion. It keeps the composition of these reserves a secret, but it’s widely believed that around two thirds of them are denominated in US dollars – largely held in Treasuries.  With the US debt ceiling at $14.3 trillion until recently, this means the Chinese authorities could hold around one seventh of the US government’s debt.

Given that Chinese GDP per capita is just $7,600 on a purchasing power parity basis (126th in the world) compared with US GDP per capita of $47,200 (11th in the world) there is clearly something awry with Chinese savers continuously funding US consumers! (Figures according to the CIA World Factbook for 2010).

After the S&P downgrade of the US, the official Xinhua news agency issued a statement calling for a new global reserve currency. However, the only credible candidate for this position would appear to be the renminbi itself, and to be the new global reserve currency it would need to be freely traded – a step the Chinese authorities do not seem ready to take.

Of course, whilst the peg remains in place the underlying imbalances continue to worsen, but every revaluation of the renminbi does mean an offsetting drop in the value of the dollar based debt currently held in the Chinese reserves. So the Chinese authorities have preferred to prolong the present unsustainable situation, rather than see a massive drop in the local value of their dollar denominated assets.

This may be changing now. Recently a publication by the People’s Bank of China said that Beijing should urgently assess the risks of being the main investor in US debt and accelerate diversification of its reserves. Were China to start unloading its dollar denominated debt rather than continuing to soak up Treasuries, that could lead to a massive problem for the US.

In an article published by Reuters on 8th August 2011, Joseph Nye, a professor at the John F. Kennedy School, Harvard and author of ‘The Future of Power’, commented, ‘If it dumped its dollars, China would bring the United States to its knees, but might also bring itself to its ankles. The situation, analogous to the Cold War’s balance of terror, where the price of aggression was the inevitable destruction of both sides, has both sides eager to maintain the balance of interdependence even as they continue to jockey to shape the structure and institutional framework of their market relationship.’

In the past few days the authorities have allowed the currency to rise, to a high of 6.3945 yuan per dollar on August 11, but fundamentals suggest this is nowhere near enough. One academic survey published in April this year, suggested that on the basis of purchasing power parity analysis, the undervaluation is around 37.5 percent (Lipman, Joshua Klein (April 2011). “Law of Yuan Price: Estimating Equilibrium of the Renminbi”. Michigan Journal of Business 4 (2)).

The only thing that seems clear at this point is that international investors should pile into renmimbi to the extent they are able to through the offshore markets.  Unfortunately, the right action for the Chinese authorities to take seems much less obvious.