American_Ultimatum

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AN AMERICAN ULTIMATUM
by Mark Tier

21-07-2005

After years of American pressure on China to revalue its currency, the

yuan,Congress recently threatened to impose a 27.5% tariff on all

Chinese imports

within six months if China doesn't revalue - or float -

its currency. A revaluation

would give speculators who'd bought yuan

an instant – and guaranteed - profit.

Let me explain. Since 1996, the Chinese yuan has been fixed at a rate

of 1 yuan = 12 US cents. If the yuan was revalued it would be worth

more ... say, 15

cents. And since this will be a new fixed rate, the

government of China would, in

effect, be committed to giving 15 cents

to each person who'd bought yuan at 12

cents.

Sounds like a good deal for buyers of yuan, right?

Apparently, currency speculators around the world agree: in 2004 $1.2

Trillion in "hot money" poured into China, China's foreign exchange

regulator said

recently.

Before you rush in to join the crowd, there are two questions you

should have answers to. First, will China revalue the yuan? If so,

when, and by how

much?

Let's take the second question first.

The answer to this question is simple: nobody really knows. Say China

Revalued the yuan by 10% two years from now. That would give you

a 5% per

annum return on your capital. Not very interesting. (And nor

would it satisfy the

Americans.)

Of course, it could be more, and it could be sooner. But whatever it

turns out to be, the ultimate profit is uncertain.

If there is to be a profit...

A major attraction of buying yuan is the general assumption that

there's no downside risk because there's only one way that Chinese

currency can

go: up. But is this true?

To answer that question, imagine you're president of China's central

bank. You have some choices. You could do nothing. You could

revalue the yuan.

You could devalue it. Or you could float the

currency, so its exchange rate would be

set by the free market instead

of government fiat.

Looking at the economic data, it's hard to find anything that would

justify a revaluation. For example, according to a Federal Reserve

Bank of Cleveland

analysis, in the 10 years the yuan has been fixed to

the dollar, its real value has

actually fallen against the greenback - if

only by 2.4%. That implies it's really worth

less than 12 cents.

Secondly, that $1.2 trillion inflow of "hot money" that I mentioned

above, when converted into yuan, has caused China's money supply to

explode. It

was up 14.4% last year, compared to and increase of just

2.7% in the United States.

What's more, in the past six months, as Alan Greenspan has tightened

The screws, the supply of dollars (using the M1 measure of the money

supply) has actually declined. While Chinese yuan have become more

abundant,

dollars are actually getting scarcer! You don't have to be an

economist to figure that

the dollar should rise in value, and the yuan

should fall.

So, as president of the central bank of China, faced with this American

ultimatum, what are you going to do?

Obviously, you can't devalue the currency. That's out.

Ideally, you'd probably prefer to do nothing. That's usually the safest

bureaucratic path.

Perhaps you could try and persuade American politicians that their

demands are illogical. But logic is a poor tool to use with people who

are blinded by

their emotions and politics.

You could give in to the American demand, and revalue the yuan by

some

Amount that would satisfy them. Probably in the region of 25%.

The very next day, however, the speculators would all be knocking on

your door, wanting to turn the yuan they bought for $1.2 trillion back

into dollars at

the new, higher rate: you'd have to pay out $1.5 trillion.

The speculators' $300 billion profit would come straight out of your

Foreign exchange reserves. Better to let the Americans impose their

tariff. After all,

that wouldn't affect Chinese exports to the rest of the

world; and you'd keep your

foreign exchange reserves intact. (In any

case, most Chinese goods would STILL be

cheaper than the

alternatives - even with the tariff!)

What about letting the yuan float free?

Since most everybody seems to think the yuan is undervalued, there

Would probably be a rush into the currency, which would send it up.

But very quickly, speculators who are already there will start to take

Their profits, pushing the yuan back down. That could easily trigger a

rush for the

exits, sending the yuan into freefall.

Worse, a collapsing yuan could easily expose the serious weaknesses of

China's banking system, sparking an economic crisis the fixed

exchange rate was

designed to avoid.

Frankly, I have no idea what the president of the central bank of China

Is going to do - and I'm very thankful that I'm not in his shoes. But I

Imagine he'll move Heaven and earth to avoid giving speculators a

$300 billion

profit.

One thing, though, is clear: as is usually the case in the markets,

what seems to be a "sure thing," with a guaranteed profit and no

downside risk, in

reality has a return somewhere between zero and

something, with a very high

chance that you could lose a bundle of

money.

So unless you're George Soros, and currency speculation is firmly

within your "circle of competence," probably best to leave this one

right along.

That's what I'll be doing.

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