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China Flexes Its Muscles on Wall Street Part III: Currency Wars?
Wenran Jiang
3/24/2008

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The value of the Chinese yuan, or RMB, has been a sore spot in U.S.-China relations in recent years. Faced with a massive $256.3 billion trade deficit with China for 2007 that has increased over three times since 2000 ($83.8 billion) and continues to increase annually, Washington has called on Beijing to revalue its currency based on the presumption that it is set artificially low against the dollar—maybe by as much as 40 percent (1). Washington has demanded that the Chinese government take bold and concrete steps in raising the RMB’s value; Congress even threatened sanctions on China if it did not comply. China, however, has so far weathered the pressure for any dramatic appreciation of the yuan, citing domestic concerns and arguing that adjustments in the exchange rate will not significantly alter its trade surplus with the United States, nor would it cure America’s economic ills. Meanwhile, Beijing has made slow but gradual upward appreciation of the yuan while spending hundred of billions in dollars buying the United States' growing debt. In January 2008, China spent $492.6 billion to purchase U.S. government treasury bonds making it the second-largest buyer of U.S. debt second only to Japan. With inflation in China reaching a record 8.7 percent in February 2008, the yuan's appreciation will likely continue in part to fight domestic inflation, while the ripple effect of the sub-prime mortgage crisis in the United States continues to reverberate throughout the U.S. economy. Coupled with a presidential election campaign, debate over China's currency policy will undoubtedly heat up in the coming months. Perhaps a look at what the Chinese are writing and reading will offer some insight into what Beijing is thinking.

Fanning the Flames of Currency Wars

Currency Wars (Huobi Zhanzheng), a book written by a Chinese native who lived in the United States and worked on Wall Street, has become a runaway bestseller in China in the past nine months [2]. The book caused a sensation of interests and heated discussions in Chinese cyber space and other multiple forays on Western intentions behind its demand that China quickly appreciate the value of its currency. Song Hongbing, the book’s author, draws from a wide range of literature in English and argues that the modern history of international finance is primarily a process of how a very small number of powerful families in the West have established their control over governments and international institutions.

According to Song, there is no such thing as a free market when it comes to global finance and financial institutions. From the Rothschild family at the time of the Napoleonic Wars to the rise of J. P. Morgan, the Rockefellers and other prominent U.S. financial powerhouses, Song sees all the modern wars, depressions and men-made disasters having a linkage to the manipulation of a handful of Western private bankers. The Great Depression of the 1930s, the oil crises of the 1970s, and the fall of the Soviet Union were all apparently masterminded by the small group of Western bankers and financiers. The book’s significance and its number one spot in China today is due to the author’s argument that after Japan was brought to its knees by the forced appreciation of the yen, after the Asian financial crisis of 1997-98 that shattered the other Asian “miracle economies,” the American and European financial oligarchs are now turning their attention to China—and the form of the real Western subversion of the Chinese economy would come in the form of “currency wars.”

As the book’s preface makes very clear, the West has so far been unable to stop the rise of China but there is clear and present danger ahead. The analogy here is that China is like a huge economic development “aircraft carrier,” which can take on all challenges coming from every direction. However, just as the People's Liberation Army Navy (PLAN) has in recent years built up a small but formidable submarine force that can tail and challenge the larger U.S. aircraft carrier battle groups, China’s "economic carrier" is also vulnerable to financial sub-attacks that are launched by the powerful Western financial institutions. The book warns that China must do everything possible to prepare for and defend against a coming currency war waged and led by the U.S. and other Western countries’ financial tycoons.

The $1.6 Trillion Question

The popular perception of fear is also based in part on China’s success in becoming a global financial power. Over the past three decades, the Chinese leadership has pursued a modernization program largely built on traditional economic development models: heavy industrialization, labor- and capital-intensive manufacturing industries, export-led growth, low labor cost and high environmental damages. As part of China's development paradigm, Beijing is following a basic premise laid out by old school mercantilism on the accumulation of wealth: export as much as possible while discouraging import where feasible, and the larger the trade surplus, the richer and stronger the state. This dogma has kept China’s currency value low for most of the past 30 years. Rather than let the RMB’s exchange rate be decided by the market, the government set a fixed exchange rate by pegging the RMB to the dollar. As long as GDP continues to grow by close to double digits every year, and exports expand further with a low currency value against the dollar, both central and local authorities can claim success. As China’s overall trade surplus in foreign trade led to the accumulation of more foreign reserves over the years, Beijing encountered a major problem: few people in Beijing knew how to run a more balanced trade sheet or how to effectively use the funds.

When it comes to the call for increasing the value of the RMB, Beijing is very concerned about its potential impact on China’s export competitiveness, and its impact on China’s employment rate. To ease U.S. complaints, China would often go on a shopping spree for U.S. goods before large bilateral meetings such as a summit, buying billions of U.S. goods at a time, magnifying that Beijing was indeed serious in reducing its trade imbalance with Washington. Another vehicle for China to deal with its accumulating dollars account is to invest them back in the U.S. economy by purchasing U.S. government treasury bonds.

When China finally realized that it could no longer keep piling up foreign reserves, and that it is becoming risky to hold so much, especially in U.S. dollars, Beijing implemented a major reform in 2005 that halted the yuan’s peg with the dollar and instead adopted a floating exchange rate mechanism, pegging the Chinese currency to a number of currencies other than the dollar [3]. Although the trading range was very narrow and the appreciation rate was small, the yuan has strengthened against the dollar from about 8.27 yuan to a dollar in July 2005 to the current 7:1 RMB-dollar exchange ratio.

While foreign observers have recommended that China should take much bolder steps in raising the yuan’s value by about 15-25 percent or more, and allowing a much wider band of currency trading between five to seven percent—as opposed to less than one percent—Beijing has adapted a more cautious approach (Asian Wall Street Journal, September 12, 2003). It declared that China will only raise its currency value on its own initiatives, and do so only when the domestic market is stable, and proceed with a gradual and controlled pace. However, some farsighted Chinese experts have advocated a much faster speed in increasing the value of RMB as a way of addressing China’s trade surplus problems. For instance, Dr. Yu Yongding, director of the Institute of World Economics and Politics at the Chinese Academy of Social Sciences and former member of China’s powerful Currency Committee, has argued that raising the yuan’s value against the dollar is in the fundamental interests of China. A stronger RMB, Yu writes, will certainly have an impact on China’s export volumes, and potentially affect some manufacturing jobs. But the impact will be limited given the size of the Chinese economy. Furthermore, China’s imports will become cheaper, thus canceling out any negatives that may come from the reduced exports. Ultimately, such macro-level adjustment will make the Chinese economy much healthier and more competitive [4].

Now China has come to the point of holding excessive amount of foreign reserves, which are mostly in dollars. While the pressure from the United States and other countries is increasing, the internal debates are also heating up, ranging from conspiracy theories and other arguments for radical policy adjustments. In a recent conference on globalization and its impact on China, jointly organized by the Chinese Academy of Social Sciences (CASS) and the University of Toronto, scholars from China’s top think tank passionately advocated surgical procedures that will see a sharp increase in the value of yuan as well as a total re-structuring of the Chinese economy. Dr. Wang Songqi, deputy director of the Institute of Financial Studies at CASS, contends that the best way for China to deal with its massive $1.6 trillion foreign reserve is to appreciate the Chinese currency by 40 percent, and move the Chinese economy into a more value-added industrial structure through a new type of international division of labor. In this new design, China would transfer the current labor-intensive manufacturing industries to other developing countries that have a lower wage range [5].

China: The New Kid in the Global Financial Bloc

Before radical approaches can be implemented, Beijing needs to deal with the huge amount of money in its hands. Most funds have found their way back to the United States through the continuous purchase of U.S. treasury bonds. Some of the funds have gone to investments in energy and resources around the world. Nevertheless, China has been largely unsuccessful in its efforts to gain access into the North American market, because of protectionist sentiments that raises the specter of the national security risks of having significant Chinese stakes in key U.S. strategic industries. The $18.5 billion takeover bid of the U.S. energy firm Unical by China National Offshore Oil Corporation in the fall of 2005 failed. The recent purchase plan of 3Com by China’s Wuawei Corporation—a joint bid with a U.S. company with Wuawei in minority share—also fell through. And in both cases, U.S. national security concerns cast a major shadow over Chinese intentions. In energy- and resource-rich Canada, Chinese investment remains extremely small to date.

As has been documented in the first two parts of this mini-series on China’s growing financial power, Beijing’s recent establishment of Sovereign Wealth Funds and its global investment in banking and financial institutions have also raised alarm levels on the strategic orientation of China (China Brief, November 17, 2007; China Brief, November 29, 2007).

At the same time, China Investment Corporation (CIC), a new Chinese government investment institution with $200 billion of China’s surplus dollars, has shown that it is still a long way from becoming a professional financial institution. Its large investment in Blackstone last year turned out to be a massive losing venture. With the U.S. and global economy in so much trouble, there are now opportunities for China to pour in much-needed Chinese capital around the world. Britain and Japan, for example, have expressed particular interests in CIC investment in their countries. The world today does not seem to long for any "currency wars" such as the one suggested by Song's book. Rather, it needs a well-managed process to bring down China’s trade surplus without creating a self-fulfilling prophecy, increase the value of RMB with minimal negative impact and integrate China into the world financial system to create the “win-win” situation that it needs. And Beijing may have so far the strongest incentive not to wage any currency wars but to accelerate the pace of yuan’s appreciation. In January, the consumer price index in China went up 7.1 percent from a year earlier, followed by a 8.7 percent year-on-year increase in February (Bloomberg, March 28)7. A major appreciation of the RMB, together with raising the interest rate further, is seen as the most effective way of bringing China’s ongoing inflation under control.

Notes

1. Eduardo Porter, “A Rising Yuan Won’t Lift All Boats,” New York Times, August 7, 2005.
2. Song Hongbin, Huobi Zhanzheng (Currency Wars), Beijing: China CITIC Press, 2007.
3. “China adjusts yuan rate, abolishes dollar peg,” http://www.china-embassy.org/eng//xw/t204475.htm
4. Yu Yongding, “Global Imbalances: China’s Perspective,” Paper prepared for international conference on “European and Asian Perspectives on Global Imbalances”
Beijing 12-14 July 2006, http://old.iwep.org.cn/english/index.htm
5. Wang Songqi, Institute of Financial Studies, the Chinese Academy of Social Sciences, “Structural Reform of the Chinese Financial System: Challenges and Opportunities under Globalization,” paper presented at the conference on Globalization and Sustainable Development, Beijing, March 12-13, 2008.

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