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China

PART 1: Follies of fiddling with the yuan
By Henry C K Liu

Dollar hegemony emerged after 1971 from the peculiar phenomenon of a fiat dollar not backed by gold or any other species of value, continuing to assume the status of the world's main reserve currency because of the US's geopolitical supremacy. Such currency hegemony has become a key dysfunctionality in the international finance architecture driving the unregulated global financial markets in the past two decades. China's overheated economy is the result of hot money inflow caused by dollar hegemony. China's developing economy should be able to absorb huge amounts of capital inflow, but dollar hegemony limits foreign investment to only the Chinese export sector, where dollar revenue can be earned to repay capital denominated in dollars. Since China's export sector cannot grow faster than the import demands of other nations, excessive dollar capital inflow overheats the export and exported-related sectors, while other sectors of the Chinese economy suffer acute capital shortage.

Overheated economies produce growth-inhibiting inflation through excessive import of money and sudden rises in prices for imported commodities and energy. The imported inflation is then re-exported, causing inflation in other parts of the global economy. Inflation causes interest rates to rise, which in turn causes unemployment and recession in all economies that are plagued by it.

China's currency, known as the renminbi (RMB) yuan, has been pegged to a fiat dollar within a narrow band (0.3%) around an official rate of 8.28 to 1 since 1995. Even though the yuan is still not entirely freely convertible, any change in dollar interest rates will impact yuan interest rates due to the peg.

While the linkage between exchange rate and interest rate is direct, the exchange rate policies of most countries do not always operate in sync with their interest rate policies, leading to imbalance and disequilibrium in their economies. This is because these two related policies impact different segments of the population differently. Thus conflicting political dynamics push them in conflicting directions.

Capital generally prefers a strong currency since it reflects financial strength, while labor prefers a weak currency to boost exports that provide domestic employment. Capital prefers high interest rates for better returns while labor prefers low interest rates for cheaper consumer loans and affordable mortgages. China will be no exception as its moves toward interest rate liberalization and free currency conversion.

Dollar hegemony enables the US to be the only exception from macroeconomic penalties of unsynchronized exchange rates and interest rates. The US, because of dollar hegemony, is the only country that can claim that a strong currency that leads to trade deficits is in its national interest in a global economy dominated by international trade. This is because a strong dollar backed by high interest rates helps produce a US capital account surplus to finance its trade deficit.

While other economies must earn dollars to finance their dollar deficits, US trade and fiscal deficits need only be repaid with dollars that the US can print at will, not from dollars that the US must earn. That in essence is the benefit of dollar hegemony to the dollar economy. But while dollar hegemony is good for the dollar economy, it imposes costs of job loss and a debt bubble on the US economy.

Off the dollar, and back
China's exchange rate policy is not always synchronized with its interest rate policy. Currency control has protected China from severe macroeconomic penalties so far. On the exchange rate side, China has changed the exchange value of the yuan many times since its introduction on January 1, 1970, when currency reform substituted 10,000 renminpiao for one RMB yuan fixed at an official rate of 2.46 yuan to a dollar. After the collapse in 1971 of the Bretton Woods regime of fixed exchange rates based on a gold-backed dollar, pressure grew to appreciate the yuan against a floating dollar no longer backed by gold. With the RMB's theoretical gold content unaltered, a new official rate was set on December 23, 1971 at 2.26 yuan to a dollar. The alarming free fall of the dollar led China to tie the yuan to the Hong Kong dollar and the British pound sterling.

Hong Kong shifted from a rule-based currency board to a discretionary currency board over the course of its monetary history. From 1935 to 1967, Hong Kong as a British colony operated a classic colonial currency board pegged to the pound sterling, except that private banks - not the government - issued the currency, a practice that continues to this day. Instability in the value of the pound in the late 1960s pushed Hong Kong to switch to a dollar peg. The dollar, too, came under speculative attack after 1971. To avoid sinking with the dollar, Hong Kong also decided to let its own currency float. It worked reasonably well until the commencement of Sino-British negotiations on the return of Hong Kong to China, which unleashed wild speculation against the Hong Kong dollar, pushing the free-floating exchange rate temporarily to 9.6 to 1 on September 24, 1983.

By the end of October 1983, Hong Kong had ended its brief experiment with floating exchange rates and announced that it was pegging its currency to the dollar at a rate of 7.8 to $1 with a discretionary currency board regime. The peg amounted to an official devaluation from the pre-crisis floating market rate of 4.6 to 1 to defuse market panic. In 1985, two years after the adoption of the HK peg, the Plaza Accord, aiming to halt the rising US trade deficit, pushed the already steadily falling dollar sharply further down against the yen. The Hong Kong peg produced a sharply undervalued Hong Kong currency that in turn gave birth to a bubble economy that burst 12 years later in 1997 as part of the Asian financial crisis.

The independent yuan
In April 1972, with the Hong Kong currency free floating, China began listing an official effective rate for the yuan independent of the Hong Kong currency. On August 19, 1974, the effective rate of the yuan was pegged to a trade-weighted basket of 15 currencies, the composition of which was undisclosed to the market. The effective rate was fixed almost daily to the floating market value of that basket. By December 31, 1979, the yuan's effective rate rose to 1.5 to a dollar when the US Federal Reserve under Paul Volcker mounted its heroic struggle to halt US inflation by raising dollar interest rates to historical heights.

On January 5, 1980, the State Council issued a decree prohibiting payments in foreign exchange within China. On April 1, 1980, Foreign Exchange Certificates (FEC), or waihuijuan, equal in value to the yuan at the effective rate, were put into circulation, issued to non-residents in exchange for designated hard currencies, for paying hotel bills, transportation fares and for purchases at Friendship Stores. Consumer prices were set at separate levels for the yuan and the FEC to reflect purchasing power disparity between the two currencies.

On January 1, 1981, a foreign trade rate with two categories was introduced for the RMB. For internal settlements under the foreign exchange allotment quota, the official rate was set at 2.80 yuan per dollar. This rate was formed by adding to the effective rate an "equalization price" for balancing export and import profits and losses, and applied to all national enterprises and corporations engaged in foreign trade as well as to receipts and expenditures in foreign exchange for trade-related transactions in invisibles such as shipping and insurance.

An experimental trading system for foreign exchange was established by the Bank of China in a few areas such as Beijing, Guangdong, Shanghai and Tianjin. A foreign exchange retention quota also permitted exporters to retain a portion of export earnings. National enterprises holding foreign exchange earned through the system of retention quotas were permitted to sell this foreign exchange to other national enterprises that had a quota for spending foreign exchange. For dealings under the foreign exchange retention scheme, the Bank of China acted as an exclusive broker, charging 0.1%-0.3%, resulting in an effective rate of 2.803-2.808 yuan per dollar. The effective rate was applicable to all other transactions, while the official rate was largely symbolic.

On January 1, 1985, the internal settlement official rate was abolished and all trade was governed by the effective rate. On November 20, 1985, authorization was granted for residents to hold foreign exchange and open foreign exchange accounts and to deposit and withdraw funds in foreign exchange. This was to serve residents who might receive foreign currency funds from relatives and friends overseas, as individuals generally did not have permission to engage in foreign trade to earn foreign currency. By the end of November 1985, the yuan, pegged to a trade-weighted basket of currencies, was trading at 3.2 to a dollar as a result of the Lourve Accord that pushed the dollar up from the downward overshoot of the Plaza Accord two years earlier. On January 1, 1986, the trade-weighted basket of currencies peg was abandoned and the effective rate was placed on a controlled float based on developments in the balance of payments and in inflation trends and exchange rates of China's major trading partners and competitors.

In November 1986, a foreign exchange swap rate was created, based on rates agreed on between buyers and sellers at over 100 foreign exchange adjustment centers available to foreign investment corporations and at first to Chinese enterprises in the four Special Economic Zones of Shantou, Shenzhen, Xiamen and Zhuhai but expanded in 1988 to all domestic entities authorized to retain foreign exchange earnings. Between July 5, 1986 and December 15, 1989, the yuan remained at 3.72 to a dollar, despite the 1987 crash in the US equity markets.

The foreign exchange swap was set at 5.2 yuan to a dollar on December 31, 1986 and lowered to 5.9 a year later on December 31, 1987, while the yuan continued to trade at 3.72 to a dollar. Early in 1988, all domestic entities with retained foreign exchange earnings were granted permission to trade in the adjustment centers, and by October, 80 adjustment centers were established. Initially, a relatively small volume of transactions took place in these markets, but the volume increased substantially after access to the centers was expanded.

On December 31, 1988, the foreign exchange swap rate was again lowered to 6.60 while the yuan continued to trade at 3.72 to a dollar in the controlled market at adjustment centers. On February 1, 1989, regulations were issued governing the use of foreign exchange obtained in foreign exchange adjustment centers. Imports of inputs for the agricultural sector, textile and for technologically advance and light industries were given priority. Purchases of foreign exchange for a wide range of consumer products were prohibited. On March 1, 1989, regulations were issued governing domestic sales in foreign currency by foreign investment corporations. Such corporations were permitted to sell in China for foreign exchange provided the sales involved purchases under the government's annual import plan, sales in Special Economic Zones and other promotional areas, and sales of import substitutes.

On December 15, 1989, affected by the continuing global impact of the 1987 crash in the US equity markets, the yuan was devalued by 21.2% to 4.72 to a dollar from 3.72. Dollar hegemony was causing the dollar to rise instead of fall in the face of a massive injection of liquidity by the Fed in the US money supply to respond to a sudden collapse of US equity markets that led to a multi-year recession. On December 31, 1989, the foreign exchange swap rate was raised to 5.40 from 6.60, while the yuan continued to trade at 4.72 to a dollar. On November 17, 1990, the yuan was again devalued by 9.6% to 5.22 to a dollar, with the foreign exchange swap rate lowered again to 5.70.

On April 9, 1991, the management of the exchange rate was altered to a procedure under which the rate would be adjusted frequently as needed in light of certain indicators of development in international exchange markets, relative price performance, and trends in export production costs. On September 11, 1991, new regulations governing the use of official foreign exchange were introduced. Priority for using foreign exchange was given to imports of agricultural inputs, interest and amortization payments and remittances, and imports of key construction projects and technology. The next priority level included raw materials used for industrial production, critical spare parts, educational materials, and medicines. Items for which the use of official foreign exchange was strictly prohibited included cigarettes, wine, clothes, shoes, small household appliances, soft drinks, film and other luxury items.

On October 1, 1991, specialized banks other than the Bank of China foreign banks that were engaged in foreign exchange business in Zhejiang and Jiangsu province began to sell foreign exchange from export and service receipts directly to local branches of the People's Bank of China (PBC), later to become the central bank. These banks were allowed to purchase foreign exchange directly from the PBC to finance imports. The State Administration for Exchange Control would manage this part of the exchange reserves under the authorization of the PBC. After December 1991, individual residents could buy and sell foreign exchange through authorized banks at rates established in the adjustment centers in conformity with exchange control regulations.

On December 31, 1991, the foreign exchange swap rate was further lowered to 5.90 to a dollar. In April 1992, revised guidelines were issued specifying the priority uses of foreign exchange in adjustment centers for goods not covered by import licenses. Imports of inputs for the agricultural sector and central and local construction projects, and advanced equipment and technology, grain and goods that met daily needs were given priority. On January 31, 1993, the foreign exchange swap rate was again lowered to 7.50 while the yuan continued to trade at 5.75 to a dollar. On July 1, 1993, the exchange rate at which the state sold 30% of foreign exchange purchased from exporters to certain enterprises was changed from the effective rate to the prevailing swap market exchange rate. On December 31, 1993, the foreign exchange swap rate was lowered to 8.70 while the yuan traded at 5.8 to a dollar.

One and only
On January 1, 1994, the effective exchange rate and the swap market rate were unified at the prevailing swap market rate. The PBC would announce a reference rate for the yuan against the US dollar, the Hong Kong dollar, and the Japanese yen based on the weighted average price of foreign exchange transactions during the previous day's trading. Daily movement of the exchange rate of the yuan against the dollar was limited to 0.3% on either side of the reference rate as announced by the PBC.

The buying and selling rates of the yuan against the Hong Kong dollar and the Japanese yen might not deviate more than 1% on either side of the reference rate; and in the case of other currencies, the deviations should not exceed 0.5% on either side of their respective reference rates. Issue of export retention quotas ceased except for outstanding long-term contracts. In addition, Foreign Exchange Certificates (FEC) ceased to be issued and those in circulation would be withdrawn gradually.

On April 1, 1994, the China Foreign Exchange Trade System (CFETS) in Shanghai (an integrated electronic system for inter-bank foreign exchange trading) came into operation. Twenty-two cities were linked to this system by the end of 1994. On July 1, 1996, foreign-funded banks were allowed to sell foreign exchange for bona fide transactions and become designated foreign exchange banks. On April 1, 1997, 12 branches of the PBC began to operate forward purchases and sales of RMB against underlying transactions on a trial basis. Two years later, on April 1, 1999, the longest maturity of forward purchase and sale of foreign exchange was extended to six from four months.

Thus on the exchange rate side, Chinese policy has always been reactive to US policy. From a high of 1.5 yuan to a dollar in 1979, the yuan, falling steadily against the dollar, has been fixed at 8.28 to a dollar since 1995 and remained unchanged through the 1997 Asian financial crisis, the 1998 and 2000 US recessions when pressure to further devalue the yuan was resisted by China. Recent US official policy of a strong dollar being in America's national interest provided the rationale for holding the yuan-dollar peg.

On the interest rate side, Chinese policy tended to respond to the needs of its banking system more than the needs of the Chinese economy. Between 1979 and 2000, the PBC adjusted loan rates on 19 occasions and bank deposit rates on 21. China last raised the yuan lending rate on July 1, 1995 to 12.06% from 10.98 when the yuan exchange rate was pegged at 8.28 to a dollar. This was at a time when the US Federal Reserve raised the Fed funds rate (ffr) to 6%, and cross-border flow of funds between the US and China was strictly controlled. The ffr is the rate at which US banks loan excess reserves to each other. While the Fed cannot directly influence this rate, it effectively sets targets for it through the way it buys and sells Treasuries to banks.

In China, eight reductions over a period of eight years since 1994 halved the benchmark yuan one-year lending rate to 5.31%. The yuan one-year deposit rate is now 1.98%. China's consumer price index rose 5.3% in the year through July, meaning that borrowers now enjoy near interest-free loans after adjusting for inflation. Industrial prices climbed 14% in the first seven months of 2004, making real interest rates negative by a wide margin in industrial sectors. Yuan bank deposits at 1.98% now suffer erosion of principal to inflation at the rate of 3.32% a year, which then as bank loans goes to support a built-in 8.69% annual profit for those who borrow at 5.31% to speculate in the industrial sectors with 14% inflation.

Clash of interests
International money flow is closely linked to interest rate differentials between economies, in the direction of the higher rate. Speculative hot money poured into China for the past two years as the Fed cut ffr to 1%. Ample liquidity triggered an investment boom in China that exacerbated inflation. The resulting negative real interest rate amplified investment demand and caused a speculative bubble. Some $200 billion has been misallocated to overheated export-related sectors by the market, with fixed investment running 20% above annual absorption rate, while non-export-related sectors faced acute capital shortages.

With a yuan-dollar peg, keeping yuan interest rates in tandem with dollar interest rates has been suggested as the only way for China to stop a further inflow of hot money. China's foreign exchange reserves rose by $67.3 billion in the first half of 2004 despite a $20 billion trade deficit that cuts the $30.3 billion in foreign direct investment to a net of only $10.3 billion. The discrepancy of $57 billion in new foreign exchange reserves growth is attributable to hot money inflows sneaking into China in the first six months of 2004, only to be transmitted through China's central bank into its foreign reserves in the form of US treasuries.

This requires the PBC to release 472 billion yuan into China's money supply. While the Fed raises rates on signs of recovery in the US economy, China is being pressured to follow the Fed's interest rate moves even when its domestic economy is slowing because of cost-pushed inflation, mostly through higher prices for imported fuel and commodities that are needed by the overheated export sector that overshoot market growth. While conventional wisdom proclaims that keeping money too inexpensive for too long is a recipe for trouble for an unregulated market economy, it is not necessarily so for a planned economy where credit allocation can be directed by government policy, or an economy with a currency control regime.

Yet Chinese interest rates have been well above US and Hong Kong rates since the Federal Reserve began cutting ffr target 13 times from 6.5% in January 2001 to 1% on June 25, 2003 and kept it there for a whole year until June 30, 2004. The Fed lowered the discount rate to 0.75% on November 6, 2002 and raised it in three steps to 2.75% for primary (generally sound) financial institutions and 3.25% for secondary (less creditworthy) institutions. Institutions use the discount window as a backup rather than a regular source of funding. This meant that banks could borrow at the discount window at a rate generally 500 basis points below the ffr until January 9, 2003 when the discount rate was set at 100 basis points above the ffr. This was another indication that the Fed was tightening credit while still injecting liquidity into the US banking system beginning January 9, 2003. The spread between the discount rate and the ffr continues to be 100 basis points for primary institutions and 150 basis points for secondary institutions.

Before dollar's short-term rate began to rise in July 2004 from its historical low of 1%, as the Fed boosted the short-term rate target for a third time this year to 1.75% on September 21, the one-year domestic yuan deposit rate at 1.98% was 142 basis points higher than the 0.56% one-year domestic dollar deposit rate and 92 basis points higher than the 1.06% one-year US CD (certificates of deposit) rate. As a result, dollar funds in the form of hot money seeking quick short-term speculative profits have been pouring into China, making it difficult for the PBC to manage rising yuan liquidity levels from the transmission of these dollar funds into burgeoning foreign exchange reserves.

As China's foreign exchange reserves increase, it faces pressure from the US, Japan, the EU and other trading partners to revalue the yuan upward. Yet China has begun to incur an overall global trade deficit that may reach $40 billion in 2004, albeit a sizable and growing surplus ($124 billion in 2003) continues from its trade with the US. Domestically, China is reluctant to raise yuan interest rates for fear of triggering massive loan defaults by distressed borrowers, leading to a crisis in the already fragile banking system, hoping instead that import-pushed inflation can be moderated from regulatory measures.

With both exchange rate policy and interest rate policy kept intact, China hopes to deal with its overheated economy with administrative means. To curb rising inflation and runaway speculative investments fueled by negative interest rates coupled with a fixed exchange rate, the government since last spring has been trying to rein in China's overheated economy by canceling projects that had started without proper regulatory approvals. Administrative measures, such as restrictions on bank loans for overheated sectors, have slowed the economy slightly in the past few months. Industrial output moderated to15.5% in July compared with a year earlier, down from a peak growth rate of 23% in February.

Time for change?
In theory, price bubbles and overheated economies are created by the interaction of interest rates, inflation, exchange rates and credit allocation policies. Exchange rate theory mandates that if two economies are linked by freely convertible currencies with floating exchange rates, free trade and free money flow, the one with higher inflation and higher interest rates will see the exchange rate of its currency fall. China now has higher inflation and interest rates than the US, thus the yuan should fall instead of rise against the dollar until the inflation rates and interest rates of both economies equalize, if the yuan were freely convertible at floating rates.

But a weaker yuan will increase the cost of imports to China thus adding further to inflation, making the yuan even weaker. A weaker yuan will also increase exports from China and reduce the supply of goods and assets in the Chinese domestic market while increasing the supply of yuan from converting dollar earnings of exporters, thus pushing up domestic prices, adding to inflation. High inflation will push up interest rates. But a rise in interest rates increases the financing cost of production, adding to inflation. High interest rates will also attract more fund inflows, thus causing more inflation. The net inflation/deflation outcome from interest rate moves then depends, among other things, on trade balance. This rationale was given by the European Central Bank as the logic of refusing to cut euro interest rates to get the EU economies out of recession. Keeping euro interest rates stable was needed to fight import-pushed inflation to lift the euro from trading below par.

There may be a case for higher prices for Chinese exports in order to correct the US-China trade imbalance, if the price increase is passed directly onto higher Chinese wages to increase domestic demand. Chinese factory wages now range from $60 a month in less developed inland regions to $160 a month in the more developed coastal regions for an almost inexhaustible labor force culturally infused with enviable Confucian work ethics. Chinese wages can double every year for a decade with positive effects on its economy. Wage-pushed inflation is beneficial to overcapacity and can defuse an overheated economy by increasing domestic demand.

The logic of revaluing the yuan, or any currency, as a means of balancing trade is flawed. It was ironic that US treasury secretary Lawrence Summers in the 1990s repeatedly lectured Japan not to substitute sound macro-economic policy with an exchange rate policy because the US did exactly that with the Plaza Accord in 1985 and with its strong dollar policy after the 1997 Asian financial crisis. Robert Mundell, 1999 Nobel laureate in economics, observed while attending a conference in Beijing this year that never before in history has there been a case where international monetary authorities tried to pressure a country with an inconvertible currency to appreciate its currency. He said China should not appreciate or devalue the yuan in the foreseeable future. "Appreciation or floating of the renminbi [RMB] would involve a major change in China's international monetary policy and have important consequences for growth and stability in China and the stability of Asia," Mundell said.

The exchange value of the yuan is not crucial to the monetary problems facing the world economy and financial architecture today. Dollar hegemony, a peculiar phenomenon in which a fiat dollar assumes the status as the world's main reserve currency is the main dysfunctionality in the current debt economy and international finance structure. China is not the problem; dollar hegemony is. China's economy, despite spectacularly rapid growth, still accounts for only an insignificant 3.5% of the global GDP, a pathetic figure for a nation with one fifth of the world's population. Its share of world trade has risen from less than 1% to 5% in two decades. Most Chinese export products are sold with a retail price of less than $100 per item. Thus self-satisfaction of alleged economic miracle is grossly premature.

After two-and-a-half decades of reform, China is still unable to accomplish in economic reconstruction what Nazi Germany managed in four years after coming to power, ie full employment with a vibrant economy that would challenge that of Great Britain, the then superpower. Post World War I Germany started with an economy in every way as devastated as China's, with no prospect of foreign credit, huge war debts and reparations and a defeatist social milieu. While Nazi philosophy is detestable, the effectiveness of the national socialist economic programs of the Third Reich cannot be summarily dismissed.

Yet China now accounts for 60% of the growth in world trade. This testifies not to China's strength in trade, but the weakness of world trade growth, which has been driven not by prosperity, but by falling wages in the past two decades. Even the rise in foreign direct investment (FDI) inflows to China is not caused by an undervalued currency, but rather by the potential of China's domestic market and growth fundamentals. Yet this potential is constrained by dollar hegemony, which forces FDI into China's saturated export sector. But this export sector cannot grow because it is built on the outsourcing of jobs from the target markets. Rising unemployment in these markets will shrink demand for Chinese exports.

Wrong target
China's trade surplus with the US, a key target in the knee-jerk criticism of China's yuan policy, has actually little direct link with the exchange rate of the yuan. This trade surplus has been nurtured by dollar hegemony by design in order to finance the US capital account surplus. China's recent export performance is primarily driven by the country's two-decade trade reforms, its abundance of low-wage labor that has remained low-wage after two-and-a-half decades. And more importantly, China's growth has been largely led by growing processing and assembly operations in China for re-export, operated by transnational corporations mainly to demolish the hard-won gains of labor movements in the capitalistic West.

Chinese exports have consistently outperformed the competition at wide-ranging values of the yuan pegged at different levels to a fluctuating dollar. The Chinese export boom persisted even during the turbulent years following the 1997 Asian financial crisis, when strong market pressure for the yuan to be devalued was resisted. The reason for this is that Chinese wages are more flexible on the falling side than on the rising side, as a result of the smashing of the iron rice bowl by market reform and a labor movement that had not kept pace with the introduction of socialist market economy.

Exchange rate movements affect the price of both imports and exports, but their impact on trade balance may only lead to changes in the volume of goods and services rather the monetary value of trade. With a stronger yuan, fewer Chinese goods may be exported to the US at a higher price; and more US goods and services may be exported to China at a lower price, but the trade imbalance in monetary value may remain the same after initial price adjustments. Historical data suggest that Chinese firms will be required by existing agreements to continue to compensate foreign investors at previously negotiated rates of return by lowering Chinese wages. The lower wages will result in lower domestic demand in the Chinese economy and eventually in the global economy. And US firms will take advantage of the exchange rate change to raise prices of US exports. The result may merely be higher inflation for the US and eventually for the global economy.

As dollar interest rates rise, China can choose to insulate the impact on yuan interest rates by re-pegging the yuan upward, or to keep the current peg by following dollar interest rates trends. But it cannot do both at the same time without destabilizing China's financial system and economy. Since the dollar is freely convertible at market rates, the dollar-pegged yuan is in effect subject to market rate fluctuation along with the dollar with regard to other currencies. Thus the stability argument of the dollar peg is deceptive. Fixed exchange rates seldom produce monetary stability; it only reflects official denial of economic reality, often at an economy's long-term peril. There are monetary policy autonomy benefits from controlled convertibility for any currency, such as insulation from dollar hegemony, but exchange rate stability is not among them. Policy-induced exchange rates require central bank intervention that will surface as costs in different forms in the economy.

In theory, rising interest rates push up exchange rates. However, this convention is only operative if rising interest rates reduce inflation. Rising interest rates can add to inflation under some conditions, pushing down exchange rates. When dollar interest rates rise, the dollar gets stronger. But despite recent corrections, the exchange value of the dollar is still at an 18-year trade-weighted high, notwithstanding record US current-account and fiscal deficits and the status of the US as the world's leading debtor nation. There is persistent talk among trade economists of the need for the dollar to fall another 20%.

The US inflation rate has been moderated by low-price imports from China. Policy-induced upward valuation of the yuan against a rising dollar will accelerate US inflation. It will drive up US interest rates at a faster pace, conflicting with the Fed strategy of a "measured pace" for interest rate moves to avoid scuttling the anemic recovery. Similarly, raising yuan interest rates may put upward pressure on the exchange rate of the yuan to the dollar, making Chinese exports more expensive in dollar terms, creating upward pressure on US inflation rates and interest rates. These pressures can be resisted, but not without costs to the US economy.

Thus, recent calls from US officials for China to simultaneously raise both the yuan exchange rate to the dollar, and yuan interest rates further above dollar interest rates are ill advised. Such moves will cause an upward spiral of interest rates and inflation in the US, China, Asia and the rest of the world. Yuan interest rates are already substantially above dollar rates, an upward valuation of the yuan against the dollar with a rise in yuan interest rates will exacerbate the destabilizing flow of hot money into China. To understand China's dilemma on interest rate policy as a key tool in its macro approach to cooling its overheated economy, one needs to understand the interlocking relationships of interest rates, inflation, exchange rates and credit allocation.

Not again
The linkage between domestic interest rates and the exchange value of a currency is very direct, with inevitable impacts on foreign trade. An illustration of this is provided by the Plaza Accord of 1985. After the US Federal Reserve under Paul Volcker raised federal funds rate (ffr) on July 8, 1981 to a historical high of 19.93% to fight an annual inflation rate of over 15% that was still rising, the exchange value of the dollar rose to cause an alarming US trade deficit, reaching 3.5% of GDP. The Plaza Accord of 1985 was a coordinated effort by the US, Japan and Germany, the three main trading nations of the world at the time, to force the US dollar to fall against the yen and the German mark, in defiance of market fundamentals, with the purpose of reducing the US trade deficit. After the Plaza Accord, the Federal Reserve moved the ffr target in a downward trend, and the ffr fell to 5.56% in October 7, 1986.

The linkage between the exchange rate and interest rates is less direct but more destabilizing. The Bretton Woods regime fixed the Japanese yen at 360 and the mark at four to a dollar until 1971. By 1985, the dollar was buying only 238 yen and 2.95 mark. Yet the US trade deficit continued unabated. The Plaza Accord of 1985 pushed the dollar down to 145 yen and 1.79 mark. The Fed then reversed its low interest rate policy in October 1986. The ffr rose to 7.76% on October 15, 1987 and yields on 10-year government bonds rose from 7% in January to 9.5%, a rise that precipitated the 1987 crash four days later.

On October 19, 1987, the Dow Jones Industrial Average (DJIA) dropped 508 points, or 22.6%, in one day on volume of 608 million shares, six times the normal volume then (current normal daily volume is over 1.4 billion shares, with top volume of 2.8 billion shares on July 24, 2002), and ending 36.7% lower from its closing high of 2,787 less than two months earlier on August 25. The immediate trigger that burst the equity bubble was identified by some analysts in hindsight as legislation passed by the House Ways and Means Committee on October 15, eliminating the tax deductibility of interest on debt used for corporate takeovers.

Interest rate levels, in combination with exchange rate policies, have both long-term and short-term relationships to the forming and bursting of financial bubbles. China now appears determined to avoid repeating past exchange rate and monetary policy errors made by the US that had induced the 1987, 1994, 1997 and 2000 crashes.

In response to the 1987 crash, the US Federal Reserve under its new chairman, Alan Greenspan, with merely nine weeks in the powerful post, flooded the banking system with new reserves by having the Fed Open Market Committee buy massive quantities of government securities from the market. Greenspan announced the day after the crash that the Fed would "serve as liquidity to support the economic and financial system". He created $12 billion of new bank reserves by having the Fed buy up government securities. The $12 billion injection of "high-power money" in one day caused the ffr to fall by three-quarters of a point and halted the financial panic, though it did not cure the financial problem, which caused the economy to plunge into a recession that persisted for five years.

High-power money injected into the banking system enabled banks to create more bank money through credit multiplying, by lending repeatedly the same funds minus the amount of required bank reserves at each turn. At 10% reserve requirement, $12 billion of new high power money could theoretically generate up to $120 billion of new bank money in the form of bank loans, if demand and borrower credit-worthiness permit, the absence of which would leave the Fed ineffectively pushing on a credit string. The injection of liquidity from the Fed cemented the Plaza Accord devaluation of the dollar into permanence without correcting the US trade deficit.

The 1987 crash was a stock market bubble burst that led to a subsequent real property bubble burst that in turn caused the Savings and Loan (S&L) crisis two years later. The Financial Institutions Reform Recovery and Enforcement Act (FIRREA) was enacted by the US Congress in August, 1989, to bail out the thrift industry in the S&L crisis by creating the Resolution Trust Corporation (RTC) to take over failed savings banks and dispose of their distressed assets. The Federal Reserve reacted to the S&L crisis with a further massive injection of liquidity into the commercial banking system, lowering the ffr from its high of 10.71% reached on April 19, 1989 to below the 3% inflation rate, making the real rate near zero until January 31, 1994.

Since there were few assets worth investing in a down market, most of the newly created money went into bonds. This resulted in a bond bubble by 1993, which then burst with a bang in February 1994 when the Fed started raising rates, going further and faster than market participants had expected: seven hikes in 12 months, doubling the ffr target to 6%. As short-term rates caught up with long, the yield curve flattened out. Liquidity evaporated, punishing "carry traders" who had borrowed short-term at low rates to invest longer-term in higher-yield assets, such as long-dated bonds and more adventurous higher-yielding emerging-market bonds. The rate increases set off a bond-market crash that bankrupted Wall Street giant Kidder Peabody & Co, California's Orange County and the Mexican economy, all casualties of wrong interest rate bets.

By 1994, Greenspan was already riding on the back of the debt tiger from which he could not dismount without being devoured by it. The Dow was below 4,000 in 1994 and rose steadily to a bubble of near 12,000, while Greenspan raised the ffr target seven times from 3% to 6% between February 4, 1994 and February 1, 1995, to try to curb "irrational exuberance". Greenspan kept the ffr target above 5% until October 15, 1998 when he was forced to ease after contagion from the 1997 Asian financial crisis hit US markets. The rise in ffr in 1994 did not stop the equity bubble, but it punctured the bond bubble. Despite the Lourve Accord of 1987 to slow the Plaza-Accord-induced fall of the dollar, the dollar fell to 94 yen and 1.43 mark by 1995. The low dollar laid the ground for the Asian finance crisis of 1997 by fueling financial bubbles in the Asian economies that pegged their currencies to the dollar.

US inflation rates have been under-reported by statisticians in the name of scientific logic. The first significant downward adjustment occurred in 1996 on the recommendation of the Boskin Commission, which had concluded that the US inflation rate had been overstated by an annual 1.1 percentage points. About half of this overstatement has since been "corrected".

America's hedonic pleasures
But further, far more substantial downward adjustments in the price indices have resulted from the spreading use of "hedonic" pricing methods, used to translate quality improvements in products into price declines even if the actual prices are climbing. Automobiles that now sell for $30,000 used to sell for $10,000, but the inflation rate of automobiles is registered as declining because cars are technically more sophisticated. The consumer is supposed to be getting more "car" per dollar, never mind no one can now buy a $10,000 car. Rents for apartments are registered as declining even when rent payment rises, because renters get air-conditioning, marble bathrooms and granite kitchens and high rise views. Yes, the higher up you are from the dirty, noisy street, the more housing you allegedly get per dollar, a real bargain in hedonic price while the square foot price goes through the roof. Thus prices can rise with no inflation.

The US Bureau of Labor Statistics (BLS) expanded the use of hedonic regressions to compare quality differences in prices. Hedonic regressions attempt to estimate econometrically the value that households put on quality differences. These methods are used for measuring quality distinctions in the categories of apparel, rent and computers and peripheral equipment, and as of January 1999, they have been used for television prices. Research is under way to extend this technique to other categories.

As this measuring technique is being extended to a growing number of goods, it has become a most important factor in reducing the US inflation rate, and intrinsically raises nominal GDP growth while the real GDP may actually decline. Its overall effect on monitoring the economy is kept secret from the public. The hedonic price adjustments for computer hardware and software alone went a long way to explain US growth and productivity miracles of the past decade.

Another device to lower the measured US inflation rate is the shift to "chained" price indexing, used since 1996. It changes the weight of items in a basket of goods on the assumption that people generally tend to shift their spending to cheaper goods. If the price of apples rises, people buy more pears, whose lower prices go into the price index instead. It is reasonable to suspect that US inflation before the 2001 crash had been hovering around 5% on the old basis, the highest in more than a decade, and virtually twice the rate in Europe. Inherently, this would have cut real GDP growth by about 1.5 percentage points and kept interest rate higher. All this suggests two important things: first, that the reported new paradigm increases in real GDP and productivity growth have been exaggerated by a statistical illusion; and second, that real interest rates have been far too low in relation to real inflation, which also explains the most rampant money and credit creation that the US has ever seen in recent history.

Hedonic price indexing, by keeping the official inflation rate significantly lower than reality, not only played a key role in fueling the stock market boom, but also magnified the budget surplus during the Bill Clinton years and now understates the George W Bush deficit. Such indexing reduces social security payments and welfare benefits across the board, as well as undercutting inflation-related wage adjustments. Essentially, lower hedonic prices in computers and electronic gadgets are paid for by less money for food and housing of the elderly, the unemployed and the indigent as well as the average worker.

The most troublesome fact is that the BLS does not keep contemporaneous calculations of the "old" method for historical consistency, or reveal the degree of "new" versus "old" distortion. This cover-up opens government statistics to challenges of reporting honesty. Bill Gross of PIMCO, the world's largest bond fund, recently wrote: "The CPI inaccurately calculates Americans' cost of living. Since social security and pension benefits as well as the level of wage hikes are predicated upon the specific number and/or the perception of annual increases, Americans are being in effect conned by their government and falling behind the inflationary eight ball year after year. After slamming the concept of the core CPI, the primary culprits I cited were the government's use of hedonic and substitution adjustments to lower the CPI by as much as 1% in recent years."

Look who's talking
Greenspan made his famous "irrational exuberance" speech at the American Enterprise Institute in Washington DC on December 5, 1996, when the Dow was at 6,437, more than twice of the pre-crash 1987 high. Yet the market kept rising and on January 14, 2000, the Dow peaked at a hyper-irrational level of 11,723. Two months later, after settling down to hover around 10,000, it experienced its largest one-day point gain in history - 499.19 - to close at 10,630.60 on March 16, 2000. John Maynard Keynes, who famously warned that markets can stay irrational longer than participants can stay liquid, must have been laughing from heaven.

Greenspan either failed to link the rise of equity prices to an undervalued dollar or he deliberately skirted the issue because foreign exchange value of the dollar was the province of the Treasury, not the central bank. Either way, there was nothing irrational or exuberant about the effect of a fall in the exchange value of the dollar on a rise in US equity prices. It was a causal effect of a finance bubble fueled by an undervalued currency, especially when price increases can be viewed as causing no inflation through hedonic regression.

On April 14, 2000, some 22 trading days after its largest one-day point gain, the Dow plummeted 617.78 points, closing at 10,305.77 - its steepest point decline in a single day historically so far. This volatility came purely from speculative forces operating on a bubble. The economy did not change in 22 trading days. When the Dow started its slide downward after peaking at a historical all-time high of 11,723 on January 14, 2000, the Fed lowered the ffr target from 6.5% on January 3, 2001, but could not halt the decline. After the Dow hit a low of 7,524 on March 11, 2003, the Fed lowered the ffr target to 1% on June 25, 2003 and kept it there until July 2004. Since then, the Dow, having climbed steadily to peak at 10,737 on February 11, 2004, fell back to 10,121 by August 31, 2004 when the ffr rose to 1.5% and closed at 9,988 on September 27 with the ffr at 1.75%.

The US trade deficit was 3.5% of GDP at the time of the 1987 crash. It was 5.4% by the end of the first quarter of 2004 and rose to $166.2 billion for the second quarter of 2004, annualized to $664.8 billion, or 6.5% of US-projected GDP. With every passing day, more market watchers are joining the rank of those predicting looming financial crisis in US markets from excessive debt, particularly external debt. This danger cannot possibly be defused by China, regardless of what monetary policy it adopts. The dismal record of US monetary policy that induced the 1987, 1994, 1997 and 2000 crashes discounts the value of US advice for Chinese economic and monetary policy.

Too much of a good thing
By 1994, excess liquidity had fueled a worldwide equity rally that found its way into the Asian emerging markets, where it fed an unprecedented bubble of easy money in the form of undervalued currencies pegged to a falling US dollar. When the Asian emerging market rally crashed abruptly on July 2, 1997, starting with the Thai central bank running out of foreign exchange reserves trying to maintain its currency peg, followed by the Russian debt crisis in 1998, all the major central banks of the world reacted yet again by pumping even more liquidity into the global banking system. Initially, this flood of hot money inflated another bond bubble, which popped viciously in 1999. Then, more liquidity boosted equity prices further and provided the fuel for the enormous high-tech, Internet and telecom stock bubbles of 1999 and early 2000.

The first three years of the 21st century saw a worldwide equity market crash followed by a recession plagued by overcapacity, over-indebtedness and over-leverage. And the responses of central banks were always more liquidity through lower short-term interest rates, which helped pump up the bond bubble in 2003, with the high fixed yields of outstanding long bonds translating into higher bond prices. Excess liquidity supported artificial rallies in housing prices, equities, corporate debt, commodity prices and mushrooming emerging markets, particularly China. Fools are calling it a US-led recovery.

The Fed was caught again in its own ideological vice between contradicting interest rate policies to balance stimulating growth and preventing inflation. To avoid the boom-and-bust cycle, the Fed attempted to drive its monetary vehicle in opposite directions at the same time, simultaneously fighting inflation and stimulating the economy. Despite the Fed's announcement that it will raise interest rate to ward off inflation only at a "measured pace", much talk of a repeat of a 1994 burst of the bond bubble has since been circulating. Pushing China to raise yuan interest rates now will only heighten the Fed's difficulty in keeping its "measured pace" of interest rate hikes.

Bond traders know that a five-year duration bond fund can drop 5% in value with an interest rate rise of one percentage point. Conversely, a one percentage point drop in rates would cause the same fund to increase by 5% in value. For long-term bond funds with effective durations of at least seven years, a rise in long-term interest rates of 2 percentage points over the next 12 months would cause at least a 14% drop in value. With yields on long-term Treasury bonds now around 5%, such an increase would translate into a loss of 9% or more for shareholders - similar to the last time the Fed tightened monetary policy in 1994.

Many market participants intuitively concluded that long-term rates, following the ffr, would also rise, causing prices of outstanding long bond to decline. Speculators shorted Treasury long bonds - that is, they borrowed bonds to sell by promising to return them at a later date when they hope to buy back the same bonds at a lower price, profiting from the anticipated price differential. But long-term rates moved counter-intuitively in the credit markets. What the short-sellers failed to take into account was that foreign central banks now must buy each day between $1-2 billion of government bonds to park the additional foreign exchange reserves they earn from the US trade deficit. This was a factor of much smaller scale and consequence in 1994 when the bond market collapsed from the Fed raising the ffr target in quick succession.

Because traders grossly misjudged the bond market's likelihood to rally in the face of the Fed tightening and stubbornly hanged onto conventional intuitive moves in expectation of an easy killing, throwing in the towel only when it was too late, the rush to cover short positions pushed bond prices even higher from technical effects of a short squeeze. On Wednesday, September 22, the 10-year-note fell below the psychological 4% (3.98%) for the first time since April when the Fed made its third tightening in 2004. That shifted market sentiment, and traders decided to stop throwing good money after bad just to humor Greenspan's fantasy of a recovery. They reacted to the rise in bond prices as a signal to buy more. It was the market's vote that the economy would not be heading north for a while.

Shorting on bonds began when the non-farm payroll unexpectedly surged by 308,000 in March 2004, suggesting that an end might be in sight for the three-year-long recession and the corresponding bull run on bonds. In June, the 10-year note yielded 4.9%, only a few weeks before the Fed raised the ffr target for the first time in four years. Surely, bond prices had no place to go but down with a rising ffr, so figured the smart money intuitively. The market, however, moved counter-intuitively against the smart money. Morgan Stanley announced on Wednesday, September 22, that its fixed income trading revenue fell 35% in the quarter ended August 31 from the previous quarter due mostly to betting wrong on bond prices falling and rates rising. Most of the other big firms suffered similar fates. The October 6 Wall Street Journal reported on dismal second half 2004 bonus outlooks for Wall Street bankers and traders.

At the current inflation rate of 1.5%, the neutral rate for ffr is 3.5%, double the current 1.75% target. According to Greenspan's announced strategy of the "measured pace" of short-term interest rate rises, it may take a long time to raise seven steps of 25 basis points each to reach the level of neutrality, if ever, because below-neutral rates cause more inflation. The Fed may be pedaling hard to reach a moving target mounted on the front of his interest rate bike. The harder he pedals, the faster the target moves with him. But the longer the Fed takes to bring ffr back to neutral or restraining levels, the bloodier will be the crash of the bond market when it happens. And it will happen. Reality does not stop merely because some short-sellers lost money. Borrowing short-term to finance long-term bets is a deadly game that cannot be made safe by hedging, no matter how sophisticated the strategy. Hedging does not eliminate risk; it only transmits unit risk onto systemic risk.

Once the genie of excess liquidity is out of the bottle, it is almost inevitable that more genies will get out of more and bigger bottles to keep the ongoing bubble from bursting to avoid nasty consequences for the financial system and the real economy. In a planned economy, liquidity provided by a national bank can serve a constructive purpose by financing planned growth. In a market economy, liquidity provided by the central bank lets the market allocate credit to the highest bidders rather than to where it is needed most in the economy. This means the liquidity often ends up fueling high-profit speculative bubbles.

Central banks, led by chief wizard Greenspan, despite their central role in helping to create financial bubbles, nevertheless declare that bubbles cannot be anticipated and nothing can be done to prevent them. But central bankers comfort markets by claiming near-magical power to handle the destructive consequences of bubbles, through a one-note monetary policy of rate cuts to inject more liquidity, to save a bursting bubble by creating a bigger bubble. Greenspan asserted in his Jackson Hole symposium speech on August 30, 2002 that it is virtually impossible to diagnose a bubble with any certainty until it bursts, and even if a bubble could be diagnosed, it is not the task of central banks to target asset price, but only to control inflation and target growth. And even if central banks were to react to asset bubbles by raising interest rates, the extent of the rate hikes needed to reverse asset prices in times of exuberance might be so large that it would destabilize the real economy worse than a bubble bursting in its own course would. Greenspan has admitted more than once that one of the roles of a central bank is to support the market value of financial assets.

China's reluctance to raise yuan interest rates reflects its adherence to the Greenspan argument that the rate hike needed to slow the overheated economy is so large that serious economic damage may result, making the cure worse than the disease, particularly when China's overheated economy does not manifest itself in a typical stock market bubble, since its stock market is not fully developed. Chinese stock market performance is more reflective of anticipatory reactions to policy reform momentum than actual economic conditions.

China's price bubble is more like a mountain of foam of tiny bubbles, each with its own unique characteristics. The steel bubble is caused not by lack of demand but by bottlenecks of supply, particularly in electricity and transportation. On the other hand, the real estate bubble is caused by speculative over-investment in a stagnant purchasing power environment associated with low wages even for the growing population of middle-income earners. China has an export bubble, blown up by the US asset bubble. China's overheated inflation is not wage-pushed, but import-pushed. China is not the source of world inflation. It is a re-exporter of inflation from the skyrocketing rise of imported energy and commodity prices and from speculative profiteering.

China also faces a problem in duplicate investment. Localities understandably copy the successful investment strategies of other localities. That itself should not be a bad thing for the world's largest disaggregated domestic market. But much duplicate investment in China has been concentrated in the export sector, where demand is externally constrained. The result drives otherwise profitable enterprises into bankruptcy and exacerbates the non-performing loan problem in the banking system. The problem then is not with the duplication of investment in China's huge domestic market, but that such duplication is not directed to expand the disaggregated domestic market, but concentrated in the relatively slow growth export market.

Keep your dollars
Led by Japan and China, East Asian central banks have been acting as lenders of last resort to rising US external indebtedness so that US consumers can continue to buy Asian exports. In the process, they are exporting real wealth to the dollar economy while subjecting their own local currency economies to mounting financial strains and risk of instability. Asian central banks now hold about $2.2 trillion, or 80% of the world's official foreign exchange reserves. Dollar-denominated assets constituted 70% of these reserves in 2003 while the US share of the world economy was only 30%. Japan's foreign exchange reserves are now in excess of $825 billion and China's now exceed $480 billion and growing. Together, they account for more than half of Asia's total foreign exchange reserves that are trapped in the dollar economy, while their own economies are forced to beg for foreign capital denominated in dollars.

The US current account deficit reached a record 5.7% of GDP in second quarter of 2004 and a net national saving rate that fell to 0.4% in early 2003. It has since rebounded to 1.9% in mid-2004. The US now absorbs 80% of the world's savings not to finance economic growth, but to finance debt-fueled over-consumption collateralized by an asset bubble. In 2003, US net capital investment was 60% below 2000 levels.

US net international indebtedness is expected to reach 28% of its GDP by the end of 2004. Since 1990, foreign-owned US assets increased from less than $2.5 trillion to approximately $10 trillion at the end of 2003 - a fourfold increase, and approaching the entire annual GDP. Over the same period, US ownership of foreign assets has increased from $2.3 trillion to nearly $7.9 trillion, resulting in a negative net international investment position for the US, amounting to about $2.7 trillion at the end of 2003 when valuing direct investment at market value. But in a fundamental sense, the entire $17.9 trillion of assets are in the dollar economy regardless of location or ownership.

How is the US able to earn a significantly higher return on its assets abroad than foreigners earn on their assets in the US? Consider currency, which pays a zero return. At the end of 2003, dollars held abroad was estimated to be about $320 billion, whereas only a trivial amount of foreign currency is held in the US. America's currency circulating abroad is about half the total US currency outstanding. That means that the US economy only makes up half of the dollar economy. The reason the US can do this is because of dollar hegemony, a phenomenon created by the dollar, a fiat currency no longer backed by specie value such as gold since the collapse of Bretton Woods in 1971, continuing to assume the status of a major reserve currency for international trade. Trade is now a game in which the US produces dollars by fiat, and the rest of the world produce goods and services fiat dollars can buy.

The dollar economy is in fact devouring not just non-dollar economies, but also the US economy. The dollar is like the rebellious computer HAL 9000 in Stanley Kubrick's 1968 film 2001: A Space Odyssey. Hal 9000 was programmed to believe that "this mission is too important for me to allow you to jeopardize it", and proceeded to kill everyone who tried to disconnect it. Dollar hegemony kills all, pushing down wages everywhere with no exceptions made for nationality. As Pogo used to say: "The enemy, it is us."

The issue is not whether Asian central banks will continue to have confidence in the dollar, but why Asian central banks should see their mandate as supporting the continuous expansion of the dollar economy at the expense of their own non-dollar economies. Why should Asian economies send real wealth in the form of goods to the US for foreign paper instead of selling their goods in their own economy? Without dollar hegemony, Asian economies can finance their own economic development with sovereign credit in their own currencies and not be addicted to export for fiat dollars. As for Americans, is it a good deal to exchange your job for lower prices at Wal-Mart?

Next: Macro measures and bubbles

Henry C K Liu is chairman of the New York-based Liu Investment Group

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Oct 23, 2004
Asia Times Online Community




BEST OF HENRY C K LIU


Fed's pugnacious policies hurt economies (Jan 10, '04)

America's selective strong dollar policy (Aug 14, '03)

China vs the almighty dollar 
(Jul 23, '02)

US dollar hegemony has got to go (Apr 11, '02)

 


   
         
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