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Thursday January 27, 2005 - 14:47:23 GMT

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Yuan is the wrong target

Yuan is the wrong target

Overall, there is a 10% chance that the Chinese will announce a yuan revaluation at, or soon after, the G7 meetings. It is much more likely that there will be a medium-term commitment to currency-market and wider market liberalisation.

The markets are likely to remain in uneasy equilibrium on such a policy with further Asian dollar accumulation. The real issue is that the US policies should be the major focus rather than the yuan. The underlying market stresses will continue to build unless the US imbalances narrow and there will be an increasing risk that the dollar will again bear the brunt of market fears later in 2005.

There is a 10-20% chance of a major political row over US deficits and policies at the G7 meetings. In this case, the US dollar and Wall Street would be vulnerable to shorter-term downward pressure.

No need for panic

The February 4-5th G7 gathering has been a major currency-market focus over the past few weeks. There are certainly important issues that need to be tackled, although the economic trends, generally, have actually been benign. The governments can still be fairly relaxed over the near-term global economic outlook. Growth rates are firm in the US and UK while Japan and the Euro-zone are at least not in recession even if growth rates are uninspiring.

Despite the currency-market focus and dollar weakness, the financial markets in have not given major cause for alarm. Bond yields have been stable and equity markets remain comfortably above the levels seen in 2003 when solvency issues were a serious concern. There has also been no obvious evidence of financial-market stresses with emerging-market yield spreads narrowing sharply over the past year.

G7 will push for market forces

Currencies are important, not least because the markets are reflecting the underlying global-economy stresses. The widening US current account deficit and Asian resistance to currency gains is resulting in a huge build-up in dollars held in Asia which is likely to be unsustainable in the medium term. The G7 focus will be on the Chinese yuan and the potential for a revaluation.

Chinese officials have stated that they need more time before considering a more liberalised exchange rate system, although they have also stated that there will be in-depth discussions over the issues. The US, in particular, will press for Asian rates to be set by the markets and Europe also wants Asia to take a greater share of currency appreciation. Without a yuan policy shift there will be more general resistance to appreciation throughout Asia.

No sense in yuan float

Any moves to free the yuan would also require greater liberalisation in the banking sector and capital account which would unleash powerful and unpredictable forces on the Chinese economy. Overall, it is much more important for the world economy that China manages a successful and gradual opening up of the capital account and strengthens the banking sector rather than lets the yuan suddenly float.

There is certainly a case for a stronger yuan, although a one-off revaluation, even in the region of 20%, would not have a major impact on the US trade deficit. Given the vast US dollar reserve holdings there would also be a steep Chinese cost due to a devaluation of dollar reserve assets. Revaluation could also lead to further speculative capital inflows into China. There is a strong case for switching the yuan to a trade-weighted basket within a narrow trading band. The yuan would be able to adjust in the event of a further dollar decline and there would also be a mechanism for allowing a gradual real appreciation of the yuan over the next few years as the band could be widened.

Beware US/Europe tensions

From a global perspective, it is also important to promote gradual policy adjustment as rapid adjustment would lead to a high risk of global recession given the extent of imbalances. The US administration would be much better employed tacking the underlying causes of the US trade deficit, namely a shortfall in domestic savings. A gradual increase in the savings rate would ease the US deficits without the need for a sharp dollar decline.

Europe would also be better off looking at ways to boost European employment levels given that German unemployment is liable to hit 5mn this year. Strong domestic demand in Europe would ease the US burden of providing global growth leadership and help the US trade adjustment process.

The US and Europe will push the case for action outside their region, but will be less willing to take domestic responsibility and this could easily lead to increased tensions between the two sides. For the economic historians, it is interesting and worrying to note that these are precisely the same argument that prevailed in 1987 before the Wall Street crash.


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