China Revaluation

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Revaluation

Impact

Forecasts


	Pros			Cons

	Cheaper Imports			Hard Landing for Growth

	More Foreign Investment and Government Spending			Immature Markets - Disastrous for Unhedged Firms

	Curbs inflation			Increases Value Of Non-Performing Loans In Banking Sector

	Reduces Foreign Debt Obligations for the Government			Influx of Speculative Money Will Increase Volatility

	Revaluation will force Chinese economy to become more productive

Pros

Cheaper imports.Despite a "cheap" currency, China's trade balance has been shrinking and for a few months in the beginning of 2004, it actually turned into deficit. With the recent industrialization, there has been a large increase in machinery, metals, and petroleum imports. In the past year, we have seen large rises in crude oil, copper, and steel prices. A stronger yuan would help to offset some of the recently higher prices paid for these vital imports. With the		trade balance fairly small, a revaluation would help the economy just as much as it could potentially hurt it. Lower import prices translate to lower equilibrium prices domestically on the imports themselves and their substitutes. Because the products being imported are largely inputs, lower prices could be passed along to finished consumer goods as well.

More expansion and investment overseas.One of the less obvious consequences of a stronger yuan, and synonymously, of greater purchasing power, would be an increase in Chinese firms' investment and expansion abroad. After the nation's foreign reserves rose to a record $514 billion in September 2004, China recently encouraged foreign investments by loosening its controls on capital outflows. The Chinese government hopes to have 50 mainland firms amongst the Fortune 500 by 2010, a year by which Chinese annual FDI should top $4 billion. The recent takeover of IBM's PC division by Lenovo is the latest example in a string of overseas investments, which have grown by 50% since 2000. Increasing		sales abroad is essential for Chinese companies who will be facing stiffening competition as tariffs and foreign ownership limits are progressively removed. Securing natural resources to meet the nation's demand for raw materials and fossil fuels is another pressing need. The yuan's current value makes it expensive for Chinese firms to get involved in FDI, so the government has done its best to ease the financing of such projects. For example, Huwei Technologies, a phone equipment maker, was recently awarded a $10 billion credit-line to finance overseas expansion, but such investments would be better encouraged by strengthening the yuan than through inefficient loans.

Curbs inflation.Inflation in China has only recently fallen from a 7 year high of 5.3% recorded last August. The country is now at a point where many factors are converging to create the possibility of runaway inflation in the near future. The low deposit rates have been encouraging consumers to put their wealth into real estate, which is offering much higher returns as housing prices grow. Consumer goods are also seeing strong demands by customers whose marginal propensities to consume are burgeoning as a result of higher incomes. Furthermore, China's one child per family law is contributing to inflationary pressures. A recent issue of Fortune magazine		recognized that this law has spawned a generation of only children. These young adults have no recollection of the hardships of the Cultural Revolution of yesteryear, but are instead, exposed to a new kind of revolution in which foreign cultures and luxury brands have infiltrated the domestic market. They are demanding more goods which parents aren't hesitant to supply. At this pace, the paltry interest rate hike alone will not curb inflation. This is where a currency revaluation could come in very handy as a damper on overheating prices and excess liquidity.

Reduces Foreign Debt Obligations.Revaluing the Yuan helps to reduce some of China's dollar denominated external debt obligations. China currently owes approximately $180 billion of external debt, the value of which will be reduced by the amount of Yuan's appreciation in real terms against the major currencies especially the dollar. (As of June 2004, out of China's $220.98 billion of external debt, $180.47 billion is foreign debt while $40.52 billion is trade credit), Market estimates through NDF (Non-Deliverable Forwards) prices that pegged Yuan is approximately undervalued by 15% against its		current market value. An revaluation of the yuan could reduce the principal amount of foreign denominated debt by approximately 15%, assuming that the debt obligations are in US dollars, which in effect reduces China's liabilities by about $27 billion dollars. With such a potentially powerful debt reduction mechanism, China can currently borrow at fixed exchange rates and in the future artificially reduce its interest payments and principal repayments by floating its currency and let it appreciate against the majors, thereby reducing the amount of CNY it has to repay.

Revaluation will force Chinese economy to become more productive. Although revaluation will most certainly impose some economic cost on China, it could also force China's economy to become more productive. China's economy is currently excessively export oriented which can be dangerous. Take Japan as an example, although it is the 2 nd biggest economy in the world and one of the world's richest nations, Japan has suffered from chronic deflation and 3 recessions in the last decade because its emphasis on the export sector left the country's internal demand underdeveloped. Samuel Brittan who is a highly respected economics writer for The Financial Times said, "If an imbalance is allowed to persist too long, a deficit country acquires an excessively home-based industrial and commercial structure, while the surplus country becomes excessively export-oriented. . . .This makes adjustments needlessly painful and difficult when they are made. And there is a risk of high transitional unemployment while resources are being transferred. " This is precisely the reason why China must		allow its currency to float sooner rather than later. If China waits for too long, its economy will become too dependent on exports and could incur a huge transitional cost if global demand suddenly drops off - leading to a possible depression throughout the whole economy. By letting its currency revalue, China will not only be able to diversify its economy to a more balanced mix of domestic and export industries, but it will also make the export sector more productive. Undoubtedly, the rise in the value of the Yuan could hurt Chinese manufacturers, as output prices rise. Initially they will have to absorb most of the cost in their profit margins. However, by forcing industry to compete on quality rather than allowing it to obtain a competitive advantage mainly as a result of lower currency, the Yuan revaluation will make Chinese manufacturers much more productive and efficient. In the long run, domestic enterprises and the export enterprises will be able to create higher value added products and generate more wealth for Chinese economy.

Cons

Hard Landing Stops Growth.Yet, a stronger yuan would also carry a number of negative effects. The Chinese economy is heavily export-dependent, and the nation still requires strong output growth to find jobs for millions of underemployed people in rural areas. Many state enterprises also employ surplus workers, and the IMF predicts the unemployment situation will only worsen. A stronger yuan would make Chinese goods more expensive to foreign purchasers, curtailing the quantity of output demanded and ultimately hurting exports. A drop in revenue would make it more difficult for Chinese firms to turn profits and if they		were to respond by firing current employees or by no longer hiring new ones, the unemployment rate would surge. The economy is currently growing at over 9%, but even a slight decrease in output might shock the labor market and growth. Especially in the short run, a stronger yuan would increase the cost of labor and of foreign direct investment. The extent of these effects would of course depend on the abruptness of the yuan appreciation, but it is difficult to envision a transition smooth enough to allow for the economy to adjust without repercussions.

Immature Markets - Disastrous for Unhedged Firms. China's financial markets, which are too new and immature, cannot handle a quick revaluation. It wasn't until 1980 that the securities and futures markets were first introduced in China. The Shanghai and Shenzhen stock exchanges weren't established until the end of 1990 and even then, they were essentially a tool for the Chinese government to funnel private funds into the state-owned enterprises. A real effort to open up the financial markets was fueled by the WTO accession and the stipulations of the agreement. The China Securities Regulatory Commission (CSRC) has always encouraged companies to list overseas in more developed markets. China's futures market opened up in October 1990 and was exposed to 3 years of disorder involving non-standardized contracts, unreasonable terms, and poorly managed exchanges. Currently, there are only 12 types of futures that are traded and they're mainly agricultural products and metals. According to a CSRC report from April of revalued suddenly, (for example, due to pressures from other countries or speculators), it would be disastrous for the countless number of unhedged, financially unsophisticated firms. Of course, the government has recognized and is trying to deal with this issue. On March 1, the Chinese government unveiled a new set of rules enabling foreign banks to directly trade derivatives with domestic firms. During the three months up to November of this year, 10 foreign banks have been granted such licenses. The new regulations allow for credit, fixed income, and currency derivatives and most importantly,

hedging instruments. The big rush seems, very logically, to be in foreign exchange hedging with Credit Suisse First Boston and ABN Amro Holdings at the head of the pack. Even if these products are available in the near future, it will take some time to get the word out and properly protect China's export-sensitive firms against revaluation losses. The question is how successful the government is going to be in holding off any large yuan movements until Chinese businesses are able to adjust.

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Increases Value Of Non-Performing Loans In Banking Sector.Although a revaluation of the Yuan reduces the foreign debt obligations of the government, it increases the risk for default on non-performing loans for the country's banking sector. As a result, the Chinese economy may not be ready to let go of its pegged yuan safety blanket. China's banking system has a significant amount of non-performing loans and although there's been a mobilization to		solve this problem, with many of the NPLs being exported and bought by large US investors, it is still a problem that exists to some extent. An increase in the value of the yuan will automatically increase the value of the NPLs. At the same time, don't forget that the Chinese government has massive amounts of US dollar assets, which they used to peg the yuan. These assets will lose value in proportion with the revaluation of the yuan.

Influx of Speculative Money Will Increase Volatility.Additionally, there has been a huge foreign capital influx into China recently purely from currency speculation. Once the revaluation occurs and investors feel as thought they've made enough profits, this capital will flow out of the economy. If it revalues too slowly, it may just be a signal to hesitant investors that more appreciation is to come. If the

pace is too fast, too many funds may leave at once. Depending on the rate at which China's central bank decides to revalue, this may or may not turn into a dangerous situation of capital flight. Either way an increase in volatility is assured. Many investors may not want to remain invested after a revaluation especially with the deliberate pullback of the economy curbing possible gains from non-currency related means.