Tuesday, May 16, 2006

It's the End of the World as We Know It

And it's not just the dollar slipping below 8:1 against the RMB.

"If you asked me two years ago when [the] yuan could become fully convertible, I would have said it would be in [the] remote future - in 15 or 20 years. But today if you ask the same question again, I'll say this could happen well within 10 years, or even likely three years later," said Lee, who is known as the "godfather" of Hong Kong's financial sector.

Wu Zhong,
The People’s Forex Liberation Army, Asia Times May 16, 2006

To me, the backstory of Chinese currency reform has been memories of the Asian financial crisis of 1999. China escaped unscathed because its currency was not freely convertible and therefore not vulnerable to revaluation, manipulation, or speculative attack.

Now, Wu Zhong’s story indicates a different imperative at work today: the Chinese government is finding the burden of being the virtually exclusive holder and manager of China’s vast foreign exchange reserves excessively onerous.

The result is an opening toward de-regulatation and decentralization--and covertibility, perhaps in a limited sense.

The new slogan is Forex for the People!

Individuals and entities will be permitted to hold foreign exchange reserves and invest them both in domestic markets and overseas.

For “qualified investors”, it’s already begun. Again from Asia Times:

With the approval of the State Council, the National Social Security Fund became the first qualified institutional investor to put money into overseas stock markets, with the Hong Kong market its top priority. The news drove Hong Kong's Hang Seng Index to its highest levels since the former British colony reverted to Chinese rule in 1997. This year, up to $6 billion is expected to flow out of China into overseas securities markets, which is likely to increase to up to $10 billion.

I see two drivers for the program:

First, in a Chinese world of consistently favorable trade balances, compulsory purchase of forex pours RMB into the local economy and stokes inflationary pressures. China can move to a more pro-active and rational macro-economic policy if it doesn’t have to buy every dollar that comes into the country.

Second, the Chinese government feels it already holds enough US dollars and US government debt. Maybe millions of Chinese forex holders will still keep their money in dollars and buy US Treasuries, but maybe they won’t. It’s not the Chinese government’s headache anymore.

It will probably turn out to be a headache for Chinese investors. I am anticipating a tsunami of money, followed by a tidal wave of fraud, and then an avalanche of losses.

It may be a bigger headache for us.

The implication for the US government, of course, is that it can’t rely as much as it did in the past on providing the primary, preferred destination for the overtaxed Chinese bureaucrats seeking to offload tens of billions of dollars of new forex reserves every month.

Weakening the symbiotic relationship between the US government and the Chinese government may modify the behavior of the US government: we may not feel we are hostage to China’s bankers, and may pursue more aggressive trade policies without worrying that the PRC will stay away from the next US Treasuries auction and plunge our economy into a tailspin.

It’s more likely we’ll miss that simpler world where Chinese bankers, trapped behind a wall of policy, regulation, and currency controls, had no choice but to dump their millions in the lap of the US Treasury.

With the US government notching up deficits of about $300 billion a year for the foreseeable future, it can’t be reassuring to see one of the biggest customers for our debt setting limits on the increase in its exposure.

Now we’ll have to compete with a larger spectrum of higher-yielding investment instruments available to smaller, less risk-averse forex holders, probably causing an increase in our borrowing costs and goosing US inflation as a result.

Whether the free flow of forex and a dynamic international currency market for the RMB symbolizes true convertibility—and China’s final mastery of its fears of currency manipulation—is, for me, still an open question.

The program described in the Asia Times looks to me like liberalized, privatized management of forex reserves accumulated under China’s current account—the trade surplus.

Allowing the price of that forex to fluctuate--and creating the financial markets and instruments to enable speculation in that forex--is a logical corollary. That's convertibility, at least in one sense of the word.

It does not look like China has plans for opening the capital account to speculative inflows. The Chinese government would presumably maintain the financial heft and privileged position needed to guide the value of the RMB against foreign currencies.

Hat tip to Simon World for pointing out the Asia Times piece.

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