BUT THERE ARE A BILLION CHINESE!!!!!!:

Yuan-derful:
The Chinese currency isn't the threat it's made out to be. (JONATHAN ANDERSON, December 17, 2004, Wall Street Journal)

Let's start with a few basics. What would you say if you opened the newspapers tomorrow to discover that Italy had reinstated its currency, the lira, and decided to peg its exchange rate to the euro or the dollar at a rate 15% more depreciated than the current one?

I suspect most people would scratch their heads at the move, and then conclude that it wouldn't have a substantial impact on their own lives. After all, Italy is still relatively small compared to the global economy, and 15% undervaluation doesn't seem like a lot in the grand scheme of things.

But if that's the case, then why all the attention on China? After all, at $1.2 trillion, Italian GDP is roughly the size of China's, and Italy's total foreign-trade value of $750 billion is only slightly smaller than that of the mainland. And 15% is a reasonable estimate for the extent of medium-term undervaluation of the yuan.

First-world manufacturers love to point to artificially cheap Chinese wages as the most imminent threat on the global scene. However, the fact of the matter is that artificially cheap Italian wages would hurt them much more. Why? Because most Italian industrial workers are in sectors like autos, chemicals, machinery and technology--sectors competing head-to-head with those in Italy's wealthy neighbors, where even small changes in pricing could shift orders and production between one country and another. By contrast, Chinese export workers make textiles, toys, sporting goods and light electronics, i.e., industries the developed countries mostly gave up a long time ago.

You can see this in the global-trade data. Chinese exports have been penetrating European, Japanese and U.S. markets at a headline growth rate of 35% per year--but total Asian exports have not. Overall Asian market share has in fact grown very slowly, which means that for each additional dollar industrialized consumers spend on Chinese imports, imports from the rest of Asia actually fall. This is not because China is "outcompeting" its Asian neighbors; rather, Asian countries have simply moved low-end processing and assembly functions to China, as a final stop on the production chain before shipping off to Wal-Mart or Tesco.

Of course, China benefits from the migration of low-wage assembly functions to the mainland--but this does not mean that the Chinese authorities are cynically manipulating their currency to extract maximum advantage over competitors. Quite the opposite; remember that the government introduced the renminbi peg to keep the currency from weakening in the post-Asian crisis years. In other words, the real effect of the peg was to stop Chinese wages from getting cheaper, which would have hurt other low-income economies in the region. The yuan has only come under significant strengthening pressure in the last two years.

What about all those forex reserves? Over the past 12 months, the PBoC purchased more than $170 billion in reserves, or roughly $15 billion per month. And they didn't do so out of some maniacal drive to accumulate a big pile of cash. Far from it; $15 billion per month happens to be the current price of keeping the yuan constant. As long as they maintain a fixed exchange-rate regime, the central bank is forced to intervene in the foreign exchange market to buy up excess dollars--or, alternatively, sell dollars if there is a shortfall in the marketplace. Five years ago, the forex market was roughly balanced, and the PBoC could manage the renminbi peg without buying or selling at all. Two years ago, the bank was buying up $4 billion per month. Since then, the number has tripled.

And this scares a lot of traders in the street. The People's Bank generally parks at least two-thirds of its funds in U.S. Treasuries or other dollar assets; if China were to let the yuan strengthen, they wouldn't have to buy up as many reserves. Even if the authorities moved very gradually, for example initially shifting to a "basket" regime, they might want to move their reserves into other currencies like the euro and the yen. Either way, a change in the exchange-rate regime means a drop in Chinese support for the dollar, at a time when China seems to be the main source of funding for overstretched U.S. consumers.

This is a compelling story, but probably a misguided one. To see why, ask yourself the question: Where do those billions in reserves come from every month? Over the past year, roughly half of China's forex reserve inflows came from portfolio capital, including so-called hot money flows. In effect, Chinese banks and firms have been drawing down their asset positions abroad, or borrowing money in foreign markets, and bringing these funds back to the mainland, in part to speculate on a possible renminbi move.

But this means that as private agents move out of dollars and into yuan, the PBoC is buying up the dollars and pumping them right back into the U.S. The net effect on U.S. markets from these transactions is . . . virtually zero! This is an overly simplified explanation, but very close to the mark nonetheless. Despite the apparent size of the headline reserve accumulation, China's true support for the dollar is much smaller.

Because of these distorting factors, economic theory doesn't pay much attention to what central banks are doing; instead, the crucial gauge is relative current account positions. If the U.S. is running a large current account deficit, then someone else must be running a large surplus--and it is these surplus economies that really "matter" for the dollar at the end of the day. What do the numbers look like? This year the U.S. current account deficit is expected to reach $600 billion. Meanwhile, China is running a current account surplus of $40 billion, i.e., only one-fifteenth the size of the U.S. imbalance.

Who accounts for the most of the U.S. deficit? Japan, Taiwan and Korea together should recorded a surplus of around $230 billion this year; throw in Singapore and Malaysia for good measure and the figure increases to $275 billion. You get the picture: China is a relatively small player on the global scene, and its neighbors are much more important in determining the fate of the U.S. economy.

This still leaves us with the undisputed fact that the People's Bank of China already holds a large pile of dollar assets (estimated at $350 billion or more). If the PBoC woke up tomorrow and decided to sell its holdings and buy euro or yen instead, the negative impact on the dollar would be enormous. But why would they? They already hold a fairly diversified asset portfolio, including a sizeable amount of euro instruments, so an adjustment in the renminbi peg away from the dollar should not require a big rebalancing of positions. And keep in mind that central banks are conservative policy institutions, not hedge funds, and it doesn't serve China's interests in the least to be seen shaking up G3 currency markets.

The bottom line? It's surprisingly difficult to argue that the Chinese renminbi exchange rate--or the exchange regime--has had any substantial impact on the way the rest of the world works.

Hard to believe that the obsessive overestimation of the threat from China is anything more than a remnant of Yellow Menace racism.

Posted by Orrin Judd at December 18, 2004 8:38 AM