Hamish McRae: The rise of the yuan is an unstoppable process

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The Independent Online

They share the same starting point. While the revaluation is tiny - a mere 2 per cent - this is the start of the long-awaited and ultimately more marked revaluation of the Chinese currency, a revaluation that will bring other East Asian currencies up with it.

But then they diverge. One view, the majority one, holds that these revaluations will start to correct the present global imbalances, in particular the excessive US current account deficit and the corresponding surpluses in the rest of the world, in particular East Asia. Once the markets see the numbers are heading in the right direction rather than the wrong one, the flow of funds into the US that have been supporting the dollar will be sustained and the world economy can engineer a soft landing.

The other view, the minority one, is that the imbalances are not so much the result of an overvalued dollar but of US over-consumption. So, in the absence of any cutback by American consumers, the revaluation of the East Asian currencies will, in the short term at least, lead to a deterioration in the trade deficit and could trigger the long-awaited dollar crisis.

So which is right? I don't think it is possible yet to answer that one conclusively but what you can do is to be aware of the vulnerabilities so that if the tectonic plates do start to shift at least you will have a bit of warning.

The first thing to be aware of is that there is very little sign that the US consumer is about to cut back. There is talk of US borrowers being overextended and of there being housing "froth" - i.e. not a big bubble but lots of little bubbles. But if you look at the numbers, there is little sign yet of any fall-off of demand either from the personal sector or businesses. Rather the reverse: just yesterday there were some very strong results for durable goods orders in June, up nearly 9 per cent.

While there is strong domestic demand the US economy will suck in imports, particularly from the lowest-cost producer, which is China. There is some dispute between the US and Chinese authorities about the size of the trade gap. You can see the two sides' different estimates in the top graph. But there is no dispute about the trend: the gap is getting ever wider.

But if you look at China's trade performance with the world, rather than just with the US, the picture looks rather different. What interests China is its trade position with the world, not just its position with the US.

The bottom graph shows the growth of exports and imports for the past eight years. The two lines have stuck together pretty closely and in fact for much of this time China has not had much of an overall trade surplus. The general pattern has been for the trade deficit with the US to be balanced by a trade deficit with the rest of East Asia and naturally with the oil producers. But this year growth of exports has continued to bound upwards but the growth of imports has fallen back. The explanation is not yet clear but Capital Economics reckons that it is largely because China has got better at substituting domestic production for goods that had previously been imported: boosting domestic coal production, for example, to replace imported oil.

While it is impossible for an outsider to assess the precise thinking behind the Chinese acquiescence to US pressure to move on the currency, you can at least see why it has become acceptable to them to loosen the currency peg and allow the yuan to climb a bit.

So what happens now? Let's accept the widespread perception that this is the start of a more general realignment of East Asian currencies against both the dollar and the euro. As that rolls onwards, eventually it ought to start to correct the big trade surpluses that China has with the US and the eurozone. But it could take a long time and meanwhile things may get worse before they get better.

Followers of the tortured history of UK trade crises may recall the J-curve. That is what happens to the current account after a devaluation: the trade balance plotted on a graph looks like a J. The downward bit of the first few months is because the change in the values of the currencies more than offsets any change in volume. Since the US will be paying a tiny bit more in dollar terms for its imports from China and volumes will for a while be unaffected, its trade gap may well rise through the rest of this year. I somehow don't think the protectionists in Congress are going to like that.

Still, the job of markets is to spot turning points. It seems to me that once the markets do feel that a turning point in the current account is in sight - even if it is not showing in the figures - they may well give the US and the dollar the benefit of the doubt. There has, after all, been some recent evidence that the other US deficit, the fiscal deficit, has been narrowing thanks to strong tax receipts. We should not write off the possibility of a benign outcome.

The most alarming outcome is sketched by Avinash Persaud, formerly a currency expert at JP Morgan and then State Street, now a fellow at Gresham College. He thinks the unpegging of the yuan will make it more likely that the imbalances unwind in a destabilising manner.

His argument is that there will indeed be a revaluation of the yuan and other East Asian currencies and the fact that everyone expects further movement of these currencies is of itself destabilising. While this will make a minimal difference to the US trade deficit, it will cut China's growth in half and risk plunging the country into deflation similar to that Japan experienced in the 1990s.

Further, as China and Malaysia are joined by other countries and switch pegging their currencies from the dollar to a basket, a prop to the dollar will be removed. Result: a dollar crisis. When? "My guess is by September," Mr Persaud said.

That is brave indeed, breaking as it does the economists' rule: Give them a figure or a date but never both.

What can more safely be said is that loosening the peg between the yuan and the dollar is the very start of a seismic global shift. We cannot see how far or how fast the tectonic plates will move, or the consequences of that movement. But something unstoppable has begun.