Stability, Speculation, and the Fixed Exchange Rate

Angry Bear has some good posts and comments here and here on the RMB revaluation, and specifically the issue of the fixed exchange rate that China adhered to for ten years.

Here's my two cents on why the Chinese government stuck with a fixed exchange rate for so long (and why major exhange rate changes in the future will occur by government fiat at carefully chosen intervals, and not as the result of a "free float").

I think the Chinese government clung to the 8.28:1 exchange rate for so many years because it wanted to discourage speculation while encouraging a relatively unfettered export trade.

Their forex regime is designed to make things reasonably uncomplicated on the current account, with the understanding that with a fixed exchange rate it's not worthwhile for importers and exporters to game the system with fake import and export contracts that would allow them to cycle dollars through their businesses and take advantage of the pre/post revaluation spreads.

The ingenuity of China-based enterprises in coming up with scams like this is limitless. The art is already highly developed in the techniques of transfer pricing to sequester funds overseas to reduce stated profits and to enable the offshore purchase and reinvoicing of imports at artificially low prices before they crossed the Chinese customs gate.

A fixed exchange rate was preferable to the enforcement headaches and bruising of the precious entrepreneurial spirit that would be required in trying to crack down on the fraud (abetted by corrupt government tipsters) and flood of illegal speculative cash that would accompany a fluctuating exchange rate.

As the Chinese government always takes pains to point out, it didn't manipulate the RMB/US$ exchange rate, as the U.S. has accused it of doing. It did just the opposite and had kept the rate fixed where it was since 1995 even as the value of the dollar drifted away.

That the Chinese government had to bow to political pressure and discard this stable system for one in which the currency becomes more vulnerable to speculative attack is a fact that probably doesn't make them very happy.

I wonder if the People's Bank of China will surrender to the guilty pleasure of confounding current and potential speculators with a transitory devaluation--a bull trap, you might say-- but I don't think the momentary satisfaction would be worth the international dismay that such an overt manipulation of the forex regime would evoke.

Parsing the Yuan Revaluation

Brad DeLong’s website excerpts an exchange between Nouriel Roubini of NYU’s Stern Business School and David Altig, who labors in the research department of the Federal Reserve, on the Wall Street Journal website concerning the Yuan revaluation.

An excellent exchange on Roubini's part, providing more clarity than usual.

But I found Altig's apparent confounding of "revaluation" and "forex market liberalization" completely off the mark—and somewhat dismaying, when one considers that the grey infallibility of the Fed apparently encompasses views on China that I find basically incorrect.

If China's move is anything, call it a "managed peg", with the only difference that instead of the transparency and stability of an unambiguous dollar peg, the PBOC can fiddle with the Euro, Yen, and dollar exchange rates based upon opaque policy and strategic considerations.

As I understand it, the foreign exchange markets in China exist to put buyer and seller enterprises together to smooth out current account transactions, not to set prices (the prices can only fluctuate within a derisory band), and certainly not to manage flows of speculative capital.

When the PBOC talks about "hot money"—which apparently excites Western economists with its implication that Chinese forex markets are open to the immense international capital flows that can overwhelm the price-setting ambitions of a single country--it is talking about improper forex inflows--a.k.a. illegal inflows--of speculative capital masquerading as operating or investment capital and parked in bank accounts or in real estate against an expected appreciation of the RMB.

This kind of “hot money” enters China secretly, with difficulty, and illegally, because of corruption and despite the vigilance of the PBOC. The free market invisible hand isn’t at work in the Chinese forex markets yet; it’s still government fiat disrupted by an occasional insinuating free market finger.

The Chinese have crystal clear memories of the Asian financial crisis suffered by countries with open forex regimes--which China escaped.

China's illiberal forex regime--which is more like a compulsory sale to the state of unallocated forex-denominated capital and excess forex operating funds at a fixed rate and very little like a purchase intervention to maintain some notional exchange rate, with comprehensive mechanisms meant to identify and hinder the inflow of speculative capital--has provided the Chinese government with immense foreign exchange reserves and the financial and political leverage that goes with them.

I don't think the Chinese government is complaining they have too much forex. The only downside, as Roubini points out, is sterilizing the domestic inflationary consequences of soaking up the copious RMB PBOC hands out in return for all those dollars.

If any forex-related crisis is going to bring down the Communist government, it's going to be domestic, money-supply driven inflation, not the unslaked thirst of the Chinese middle class for cheaper Kraft macaroni and cheese and whatever other seductive exports America can muster.

This makes genuine liberalization of China's foreign exchange regime unlikely.

The Chinese probably resent the fact that they were forced to revalue, thereby giving speculators increased incentive to finagle money into the country in anticipation of another revaluation.

But perhaps the most significant outcome for the Chinese is the fact that the cost of their domestic sterilization operations were cut by 2% and inflationary pressures were reduced correspondingly.

The significance for America is that China has abandoned its unipolar reliance on a dollar peg, and is now free to experiment with the implications of a multi-polar forex world in which China is insulated from genuine market pressures and can juggle the exchange rates to decrease the proportion of dollar inflows. Not exactly a big win for the American economy or free trade, IMO.

$2 Billion Here, $2 Billion There...

…pretty soon you’re talking about real money.

Ron Brownstein reports on Chevron carping that below-market rates on Chinese loans to CNOOC gives the Chinese a $2.6 billion advantage in its bid for Unocal, more than erasing the difference between Chevron’s $16.5 billion bid and CNOOC’s $18.5 billion bid.

I assume the $2.5 billion figure came out of the usual B-school legerdemain: assume a 2% interest rate advantage on $5 billion, choose a cost of capital to discount the cash flows back to a present value of…well, if that doesn’t give us the right number, let’s try 2.5%...

Brownstein reports the low-interest loan as fact buttressed by Chevron spin, but then confusingly reports a statement from a CNOOC advisor—who ought to know—that no such loans are involved.

I doubt Unocal stockholders will be impressed by the implication that Chevron and CNOOC’s offers are both at the theoretical maximum, even though CNOOC’s higher all-cash offer is contaminated with low interest funny money a.k.a. US greenbacks instead of good old rock solid Chevron stock.

For their part, the Chinese might argue that they’re entitled to a little help in their efforts to create a necessary premium in their offer to Unocal stockholders, when Chevron is hitting them with national security reviews, the American flag, and the kitchen sink.

However, CNOOC’s strategy is to claim the moral high ground by being “more capitalist than thou”. If they want their deal approved as an expression of the purest free-market, globalized commerce, they’d better publicly kiss off the concessionary financing, whether it exists or not.

China has been facing this problem in recent years. The picture of the Chinese government piling up mountains of foreign exchange reserves and at the same time running their economy on below-market loans is ludicrous.

They need to wean themselves from the low-interest financing available both from their own and foreign governments and world financial organizations, and fight the tendency to allocate capital based on murky strategic or policy exigencies instead of clear P/L considerations.

In other $2 billion news, the CNOOC side leaked its intention to put another $2.5 billion in an escrow account for Unocal shareholders.

The money doesn’t have a lot of significance—it’s only payable in the unlikely event that CNOOC wins the bidding war and decides to walk away from the deal anyway.

On the other hand, if the U.S. government nixes the deal, CNOOC gets to collect its money from the account and go home.

The escrow idea seems to be little more than public relations push-back.

That is to say, even though the Unocal deal looks like it’s going to turn into a protracted, expensive political nightmare that may very well make a purchase by CNOOC impossible, CNOOC is determined to stick it out and vindicate the support of those people who stand in their corner.

Which is to say in less kindly terms, the chances of CNOOC getting caught up in a stupid bidding war that does nothing more than exhaust the interest and patience of the world financial markets while enriching a phalanx of greedy lawyers, accountants, and media consultants immeasurably has increased significantly.

I Love the Smell of Bullshit in the Morning...

…it smells like “victory”.

Apparently Condi galpal Sonni Efron can write anything about the North Korean situation--even the truth—if she characterizes it as a “victory” for Condi Rice and our very own Dear Leader, George W. Bush.

The lede from the July 14 LA Times:

Secretary of State Condoleezza Rice scored a major victory in recent days when North Korea agreed to return to international negotiations.

However, Pyongyang’s return to the talks seems to have a lot to do with Seoul’s surprise offer to transmit 2 million kilowatts of electricity to North Korea than Bush’s high-minded intransigence, Rice’s subtlety, or the luscious repast of steak, cheesecake, and California wine with which we tempted the famished North Korean envoys in Beijing.

As the New York Times reveals, Her Riceness betrayed an unbecoming snippiness when confronted with the obvious:

A senior administration official traveling with Ms. Rice indicated that the Bush administration was startled, and pleasantly surprised, when the South Koreans told of their "very generous" energy offer, as this official put it.

Administration officials insisted that they did not know why North Korea had suddenly decided to return to the talks, but seemed to go out of their way to dismiss the South Korean offer.

"How do you know that the South Koreans made a difference?" Ms. Rice asked, in response to a question. "Have you been talking to the North Koreans about what made a difference? I think I can make the argument that a number of diplomatic efforts here by the Chinese, by the South Koreans, by the United States" were responsible. "The Japanese and the Russians have been involved too," she said.

On a more substantive if equally amusing note, the New York Times revealed that Seoul had discussed the power carrot first with Kim Jung Il, then with Bush in July during Roh’s visit, and finally—presumably having received no encouragement from the White House--sprang the electricity offer anyway.

Which means that South Korea’s patience with Bush and confidence in Rice must be at a pretty low ebb.

But that doesn’t deter La Leezza:

Ms. Rice added, "I think everybody deserves a good deal of credit for convincing the North Koreans that there were no bilateral off-ramps from the six-party talks."

Ah, sweet victory…

Spinning Through History With Condi and the LA Times

From Date Set For N. Korea Talks:

If the North Koreans return to the table ready to bargain, it will be a major victory for the Bush administration. U.S. officials said neither threats nor bribes were used to lure Pyongyang back. "There was no proximate catalyzing, arm-twisting event," a second official said.

The LA Times does better than most in reporting on the foreign policy shenanigans of the Bush administration, so I’m not sure if Sonni Efron is trafficking in sarcasm or stupidity when she follows her glowing encomium to President Bush’s North Korea policy with:

In the meantime, the South has been developing an economic assistance proposal for North Korea that Seoul officials describe as a modern-day Marshall Plan, the program used to rebuild Europe after World War II.The plan is not being proposed formally within the context of the six-party talks, but it appears designed to encourage the negotiations.

In other words, we don’t bribe the North Koreans. That’s South Korea’s job!

And no proximate catalyzing either! That’s a no-no!

Certainly no arm-twisting, either.

North Korea's neighbors envision a step-by-step process whereby the country would receive benefits as it freezes and then dismantles nuclear programs.Washington had initially ruled out rewarding North Korea in any way until the programs were dismantled, but it has recently softened its stance.

In fact, the Bush administration is in full retreat on North Korea, returning to the incentive-laden multi-lateral Clinton-era incrementalism that was supposed to be relegated to the dustbin of history in favor of triumphalist neo-con nut-twisting.

The LA Times’ unwillingness to state the obvious is, I suppose, a consummation of the sacred marriage between source and scribe that will ensure a steady stream of scoops, leaks, and spin from Condi to her favored Left Coast outlet.

China’s role in this is left unclear. It looks like China midwifed the arrangement, but is happy to leave the room when Washington and Pyongyang get it on.

China and South Korea have been pushing the Bush administration to do more to get negotiations restarted, and have urged the U.S. to hold one-on-one talks with the North, as Pyongyang has demanded. President Bush repeatedly refused.

Saturday's dinner took place at a Chinese Foreign Ministry guesthouse, but no senior Chinese officials attended, a senior U.S. official said.

If my analysis of Kim Jung Il’s nuclear strategy is correct, he raised enough ruckus that China was forced to put North Korea's security interests high on its foreign policy agenda with the U.S.A.

But the Chinese are so leery of getting embroiled in whatever mischief Kim Jung Il and George W. Bush might generate on the Korean peninsula that they use their physical absence to emphasize that they are not partners, guarantors, or even witnesses to what happens when the Kim/Bush Ying Yang magic occurs.

And if Condi continues her spinning, winning ways with the media, we won’t know what’s going on, either.

Does the Left Have a Stake in the CNOOC Bid for Unocal?

I jumped into the Unocal kerfluffle at Brad DeLong’s website last week with the observation:

China is pursuing zero-sum deals for oil, but on the Eurasian continent using pipeline exclusivity on a government-to-government basis. The idea that Beijing is going to extend some giant straw and suck Unocal natural gas from Thailand and oil from the Gulf of Mexico into its gaping maw is simply ridiculous. Does anybody see Chinese tankers chugging from distant Unocal fields to deliver oil to China at twice the transportation costs? Nope, the oil gets sold, enters the international market, and China buys the oil that's right for it on the same international market. Unocal oil looks more like free-market win-win oil. CNOOC's government backing and China's oil needs give a good assurance that the new company will be strongly financed and its operation will actually increase the amount of energy available to the international markets. The CNOOC bid makes sense in the globalized, win-win free market scenario. US opposition only makes sense in the context of the sort of crude economic warfare that economists (and government bureaucrats keen on a healthy international market for our debt) are supposed to avoid.

Now CNOOC’s prexy Fu Chengyu does his best to make me look like a Communist agent.

From Don Lee via the July 4 LA Times Chinese CEO Defends Oil Bid as U.S.-Style:


Unocal, though, is a small player in oil; the company's assets are predominantly natural gas, mostly in Asia. Overall, Unocal's U.S. production accounts for less than 1% of total American consumption of oil and gas. At any rate, Fu reiterated a pledge to continue delivering Unocal oil to the U.S. and other countries that get it now. While it's true that China needs oil, Fu said, in today's world, where crude is traded freely, economics and local rules dictate where oil is shipped."The Unocal assets in the world cannot be delivered to China, because most will be supplied to the local market," said Fu. "You have to look at the economics…. Shipping oil from far distances will cost more than from short distances."He added that most of Unocal's assets were natural gas properties, which are locked up in long-term contracts with countries such as Thailand and Bangladesh. Even if the countries where those assets are located would grant permission, analysts say it wouldn't be easy to build pipelines to reroute supplies to China.


Yes, that is the common-sense situation, which I’ve also laid out in a couple recent posts. There is no legitimate national or economic security argument that justifies opposition to the CNOOC bid.

So I don’t intend to blog on the merits of CNOOC/Unocal any more.

The politics, of course, are another matter.

China produces an interesting reaction that cuts across the usual left-right divide.

You have left of center types like me and white-shoe business Republicans in panda-hugger mode.

And you have fire-eating lefties and anti-Chicom deadenders from the far right joining to excoriate the Beijing regime and call for resolute opposition to the economic machinations of our strategic competitor in the East.

The Blue Team (rightwing) attitude, rooted in American exceptionalism, aggressive anti-Communism, and a faith in the efficacy of zero-sum confrontation with totalitarian regimes, is pretty straightforward.

The leftwing response is more…well, I don’t know if “nuanced” is the right word.

Much of the opposition stems from a visceral distaste for the CCP regime and awareness of the human rights horrors it has perpetrated over the last eighty years, culminating in the Tian An Men incident.

But some of it looks like a calculated attempt to stake out some defendable political turf for the left on national security and foreign affairs.

Americans are becoming increasingly aware that the U.S.A. is an empire, with burdens and opportunities well beyond those of ordinary nation-states. And Americans recognize that the right wing has an ideology matching this power—kick-ass unilateralism in the service of U.S. hegemony.

The Democrats and, especially the left, are having a hard time coming up with an electable package that combines traditional—and admirable—concern with human rights and social justice with a strategy that defines and manages American power in a crowd-pleasingly pro-active and hairy-chested way.

Confronting China offers a solution.

On the economic front, U.S. power is reforged as a weapon of American economic nationalism, substituting stand-up-for-the-American-working-stiff protectionism for that lockstep global coordination of US military operations and corporate interests I call “Halliburtanization”.

On the foreign affairs side, we would nobly oppose an oppressive, quasi-imperial regional power that subjugates millions of people and huge chunks of territory that would prefer to be independent. That’s an improvement on our current policy of picking small, relatively helpless countries that are struggling to emerge from economic and political colonialism and dictatorship, but have the misfortune of possessing territory or resources that the U.S. takes a fatal interest in.

Getting tough on China, in summary, provides an opportunity for the left to engage in politically correct but manly chest-thumping.

I usually agree with Steve Gilliard’s take on things, but in his underinformed and bombastic post on Unocal, he seems to veer into “righteous leftwing meathead” territory:

Yes, let's have China own an American oil company. Why not let them invest in Sun,. Microsoft and Boeing as well. Maybe they want shares in Colt and Rathyeon as well? Maybe station PLA troops to protect their interests, starting with Wal-Mart.

Hell no.

The PLA is a major investor in Chinese businesses. Letting them buy Unocal is not like letting the Japanese buy Rockefeller Center. It's a national security issue.

I am not immune to the attraction of the America-first school of economic nationalism. The Chinese manage international trade as a tool of national policy, and we should probably do the same.

However, unless rescuing the hard-working hydrocarbons of the world from enslavement by CNOOC—so they can gratefully adorn the freedom-loving balance sheet of Chevron—can be spun as a triumph of hard-nosed yet principled liberal realpolitik, I really don’t see the point of encouraging left-of-center atavism on the Unocal issue.