* JANUARY 26, 2010, 5:27 P.M. ET
Yuan Revaluation Would End China's Piecemeal Policy
By MICHAEL CASEY
Please, let the water torture stop.
Until Beijing revalues its currency, the drip, drip of monetary tightenings will continue. As with Tuesday's nervous market response to talk that Chinese banks had halted lending for the rest of January, market participants will read every measure as a sign of more to come.
The recent spate of incremental moves to attack asset inflation in China's stock and property markets—whether through temporary lending moratoriums or increases in bills yields—can do little to deflate a far bigger bubble created by the yuan's peg to the dollar: China's entire export zone.
Leaving that one untouched will only prolong and expand the risk of a major collapse when foreign demand for China's output proves insufficient to justify all the investment. When that happens, we all lose. China is the engine of growth.
The strongest argument for a yuan revaluation relies on a basic tenet of economics: distort prices and you distort resource allocation.
Relative prices for consumer goods, assets, or currencies are a gauge by which consumers and businesses make spending decisions. When those prices don't reflect true demand and supply dynamics, bad decisions get made. Because it applies to the economy as a whole, a falsely valued currency represents the biggest of all price distortions. It's not for nothing that the emerging market crises of the past two decades were mostly associated with currency misalignments.
For many years, the Chinese government's exchange-rate manipulation didn't matter so much.
After the Asian crisis of 1997, when China won kudos for keeping its peg in place while its neighbors succumbed to competitive devaluations, the yuan was left overvalued. But then the U.S. tech-stock bubble and China's 2001 entry into the World Trade Organization fueled a surge in investment and exports that quickly brought China's economic fundamentals more in line with its currency.
The undervaluation appeared after that. But it wasn't until the dollar started falling against all other floating currencies in the leadup to the 2008 crisis—and later with last year's recovery in financial markets—that the yuan's value got way out of line. When compared with, say, the euro zone's and Japan's persistent deflation threats and sovereign debt woes, China's 8%-plus growth rates make the undervaluation even more glaring.
With industrialized countries' debt-laden consumers expected to buy fewer clothes, toys and electronics than they did before the crisis, the yuan's undervaluation now has dangerous implications. It is encouraging an unsustainable glut of export capacity, which could drive global deflationary forces for years.
Some argue that China's low wages and relatively benign consumer inflation prove that the yuan isn't undervalued, because these would otherwise rise to bring the real, inflation-adjusted exchange rate in line with fundamentals.
But China's centralized control of banks, employers and their workers means these alternative price gauges are also distorted.
On the other hand, the 23% surge in China's foreign reserves last year to $2.4 trillion is a much clearer signal that its currency is undervalued.
China rightly worries that a new program of gradual appreciation would only encourage more hot money inflows.
So the alternative is to do it all in one bang. To be sure, a one-off sharp revaluation would strike a major blow at China's export base and induce a significant slowdown in the economy. But since China's competitors would enjoy an exchange rate windfall, contagion would be limited.
Either way, doing nothing and so indefinitely postponing a more violent, involuntary bursting of the bubble is the worst option.
Yuan Revaluation Would End China's Piecemeal Policy
By MICHAEL CASEY
Please, let the water torture stop.
Until Beijing revalues its currency, the drip, drip of monetary tightenings will continue. As with Tuesday's nervous market response to talk that Chinese banks had halted lending for the rest of January, market participants will read every measure as a sign of more to come.
The recent spate of incremental moves to attack asset inflation in China's stock and property markets—whether through temporary lending moratoriums or increases in bills yields—can do little to deflate a far bigger bubble created by the yuan's peg to the dollar: China's entire export zone.
Leaving that one untouched will only prolong and expand the risk of a major collapse when foreign demand for China's output proves insufficient to justify all the investment. When that happens, we all lose. China is the engine of growth.
The strongest argument for a yuan revaluation relies on a basic tenet of economics: distort prices and you distort resource allocation.
Relative prices for consumer goods, assets, or currencies are a gauge by which consumers and businesses make spending decisions. When those prices don't reflect true demand and supply dynamics, bad decisions get made. Because it applies to the economy as a whole, a falsely valued currency represents the biggest of all price distortions. It's not for nothing that the emerging market crises of the past two decades were mostly associated with currency misalignments.
For many years, the Chinese government's exchange-rate manipulation didn't matter so much.
After the Asian crisis of 1997, when China won kudos for keeping its peg in place while its neighbors succumbed to competitive devaluations, the yuan was left overvalued. But then the U.S. tech-stock bubble and China's 2001 entry into the World Trade Organization fueled a surge in investment and exports that quickly brought China's economic fundamentals more in line with its currency.
The undervaluation appeared after that. But it wasn't until the dollar started falling against all other floating currencies in the leadup to the 2008 crisis—and later with last year's recovery in financial markets—that the yuan's value got way out of line. When compared with, say, the euro zone's and Japan's persistent deflation threats and sovereign debt woes, China's 8%-plus growth rates make the undervaluation even more glaring.
With industrialized countries' debt-laden consumers expected to buy fewer clothes, toys and electronics than they did before the crisis, the yuan's undervaluation now has dangerous implications. It is encouraging an unsustainable glut of export capacity, which could drive global deflationary forces for years.
Some argue that China's low wages and relatively benign consumer inflation prove that the yuan isn't undervalued, because these would otherwise rise to bring the real, inflation-adjusted exchange rate in line with fundamentals.
But China's centralized control of banks, employers and their workers means these alternative price gauges are also distorted.
On the other hand, the 23% surge in China's foreign reserves last year to $2.4 trillion is a much clearer signal that its currency is undervalued.
China rightly worries that a new program of gradual appreciation would only encourage more hot money inflows.
So the alternative is to do it all in one bang. To be sure, a one-off sharp revaluation would strike a major blow at China's export base and induce a significant slowdown in the economy. But since China's competitors would enjoy an exchange rate windfall, contagion would be limited.
Either way, doing nothing and so indefinitely postponing a more violent, involuntary bursting of the bubble is the worst option.