International | Mar 12 2010
By Greg Peel
When a country calls in the International Monetary Fund to save it from financial ruin, which is reflected in a potential default on government borrowings, the first thing the IMF does is to require an immediate devaluation of currency. The resultant drop in purchasing power forces that country to immediately become more frugal.
Had Greece still been operating under its own currency of the drachma, then it is quite likely Greece would have called in the IMF in January rather than having to face stiff austerity measured forced by the European Union. However, because Greece is part of the eurozone it no longer has a unique currency but one shared by 15 other nations including Germany. There is thus no mechanism available for the IMF to force currency devaluation.
In the 1990s the “Little Tiger” economies of South East Asia were enjoying unprecedented economic growth as they emerged out of a peasant-style existence. Loathe to upset this wonderful growth, and inexperienced as to its potential consequences, government and monetary authorities did nothing to control the runaway train. The result was rampant inflation and soaring currency values, leading to a bursting of the bubble in 1997 and the resultant Asian Currency Crisis. The Little Tigers have been struggling to recover ever since.
Watching across the fence was China, which despite its size was still further back down the peasant existence graph and still more resolutely communist than capitalist. But China had plans to become a Big Tiger. One reason China has succeeded so spectacularly in such a short space of time is it elected to peg its currency to the world's reserve currency – the US dollar – so to avoid another Asian currency disaster.
The pegged currency meant America could shift its manufacturing base to China to exploit very low wages while the manufactured goods coming back were too temptingly cheap for Americans not to run up mountains of debt in buying them. The Chinese economy ran away faster than even China had expected, forcing a gradual shifting of the currency peg to a higher renminbi valuation. But China didn't want to risk derailing the economy by revaluing too fast, and hence China achieved 13% GDP growth in the mid-noughties when 8% was the target.
China got a shock, and was angry, when the GFC hit. But really Chinese monetary policy was fundamentally a contributing factor.
China's now back with some harsh lessons learned. Fourth quarter GDP growth hit 10.7% and the latest January-February economic data released this week have economists now extrapolating 11%. China is again explicitly targeting 8% growth, so it has some monetary tightening to do, beyond small steps already taken in 2010. China revalued the renminbi slowly by a total of 21% between 2005 and 2008 before the GFC hit in earnest, but in early 2008 CPI inflation had hit double digits. Clearly the process was too slow, and in looking for anyone else to blame, America screamed blue murder over China's artificially “manipulated” currency.
China's CPI inflation is nowhere near double digits this time, but this time China wants to fall into line with decade-long Western central bank policy by restricting inflation to 3%. Having returned from the negative in January, February CPI growth hit 2.7%. Wholesale inflation growth hit 5.4%. It's only a matter of time.
The People's Bank of China dictates not just the lending rate, as the RBA does for example, but also the deposit rate. The deposit rate is currently set at 2.25% which implies a negative real rate of minus 0.45% after inflation of 2.7%. It needs to rise, and the lending rate needs to rise in order to slow 11% growth down to 8%. In the meantime, speculative foreign capital (known as “hot money”) is flowing into China in anticipation of higher rates and a revalued currency – an unavoidable by-product of capitalism which seriously angers Beijing. The hot money encourages further economic growth and thus forces the issue on revaluation.
Domestically, Beijing is very concerned about a building property bubble which is driven by stimulus money being directed toward speculation rather than expanded housing and infrastructure construction as intended. China's property prices are now 30% higher than a year ago.
This is slightly misleading, given one year ago the Chinese property market suffered a bit of a crash post-GFC, and in fact the January price increase measured a more sedate 1.7% following some minor tightening measures. Thus Beijing does not wish to withdraw stimulus, and risk blowing the success the package has achieved to date, but it will affect a redirection of funds by offering more rural and regional support while at the same time raising bank lending rates to slow down the runaway cities.
To that end, economist consensus has the first rate rise occurring next month or in May or both. Thereafter, consensus has a 5% revaluation of the renminbi by at least year-end but probably sooner.
The effect of a stronger renminbi is to first render Chinese exports more expensive in the US and elsewhere. Rampant investment and strong competition in China has meant many businesses run on the barest of margins. A stronger renminbi means raw materials become effectively cheaper, but demand destruction could well wipe out those slim margins. It has been noted that while the average steel-producer's margin over time on HRC steel is US$50/t, currently it is only US$10/t on an HRC price of US$630/t.
However, Beijing will not mind weaker operations going to the wall, leaving a more robust industry base of the stronger operations. This is simply capitalism at work. What's more, it is noted that after 21% of currency revaluation from 2005 to the GFC, China's GDP growth had only receded slightly from its peak, not dramatically. In other words, the economy can handle it.
And last month's data suggest strong export growth has all but returned China's exports to pre-GFC levels.
Which leads ANZ's economists to suggest that a 5% revaluation may only be the low end of the range of possibilities. ANZ points out that incremental revaluation will only attract more speculative hot money, and that the only way to avoid this is to nip the situation in the bud. Bang. One full revaluation move. But ANZ also suggests anything below 5% will be too little, while anything over 10% would destroy too many export businesses in one hit. In other words, ANZ is predicting something in between, rather than the simple 5% consensus expectation, but with an accompanying widening of the trading “band”. (While the renminbi is “pegged” it is pegged within a band of values to allow a little bit of easier transaction fluctuation). A widened band could act as a precursor to an eventual free float, suggests ANZ.
And ANZ also thinks it will happen fast – faster than most “by year-end” forecasts. One reason is the US Treasury's pending April 15 decision whether or not to officially brand China a “currency manipulator”. So branded, the US government is given the power to impose punitive tariffs on Chinese exports.
Among economists, ANZ is at the “hawkish” end of the forecasting scale. Macquarie, on the other hand, is more “dovish”.
While others are focusing on industrial production numbers to extrapolate GDP, Macquarie notes that history suggests as the Chinese property market goes, so goes the Chinese economy. Property is a hefty proportion of GDP and provides a large slice of taxes to be returned into infrastructure stimulus. Given the rate of property price growth slowed in January following tightening measures, Macquarie argues the risk of “a lot of aggressive policy moves still to come” is reduced.
Never mind that Premier Wen described the Chinese property market last Friday as a “wild horse” in some cities.
The key, says Macquarie, is to watch fixed asset investment (FAI) data. Writing earlier in the week, Macquarie suggested a level of FAI around 25% would suggest investment is under control but a number around 30% would suggest overheating. Yesterday that number came in at 26.6%.
So Macquarie would likely be sticking to its guns, and not expecting swift and aggressive interest rate rises and revaluations. ANZ thinks differently. They say that if you lined all the economists in the world end to end they still wouldn't reach a conclusion.
What would a revaluation of the renminbi mean for Australia? Well for one thing, China could afford to buy more iron ore at the same US dollar price, which should be good news. But we will have to pay more for Chinese fridges and televisions. It's all a bit academic anyway, given our own currency floats freely. With rates on the rise in Australia while the US sits on hold, the Aussie is pushing up again. This undermines iron ore profits locally but makes imports cheaper.
Were the Chinese economy to slow to 8% then one must expect a similar dampening effect on Australia's GDP growth, which in turn takes the pressure off rates and the Aussie. But at least China won't be heading towards a Japanese-style bust, which should be good news for everyone in the longer term, even if stock market investors are stymied by China pulling on the reins in the short term.