Uh Oh…

An article in this week’s Economist (subscription required to read the entire article) suggests that China may actually be getting closer to the point of revaluing the yuan than I thought when I wrote about this issue last week:

Time to worry about China’s strong economy, not just its weak currency

WHEN John Snow visits Beijing on September 2nd and 3rd he will ride into town on a Harley-Davidson—in spirit, if not reality. As America’s Treasury secretary promised workers at the motorcycle maker’s Milwaukee factory earlier this month, the main purpose of his trip is to talk tough with his hosts about China’s currency. In the eyes of America, as well as Japan, South Korea and a host of other nations, an undervalued yuan is unfairly boosting Chinese exports and leading to lost jobs at home.

America’s attempted strong-arm tactics over the exchange rate are proving a nuisance for the Chinese government by encouraging inflows of “hot money” that are a bet that the yuan will soon be revalued…

The broad money supply surged by 21% in the year to July, the fastest rate of growth for five years (see chart), causing the PBOC to give warning of “an excessive increase” in lending. Total loans by financial institutions hit 525 billion yuan, up 71% year on year. Investment in fixed assets was nearly a third higher in the first seven months of 2003 than in the same period of 2002.

A booming money supply can indicate that higher inflation is on the way. That may seem odd in China, which spent much of last year struggling against deflation and where the consumer-price inflation rate is still only 0.5%. For the time being, likelier problems are roaring asset prices and a further increase in China’s already enormous bad-debt problems, fuelled by ill-considered lending. The signs are already there. Car sales [are] up 82% in the first half of the year and prices of luxury properties in Shanghai [have soared] 172% over the same period…

Policymakers are reacting. Verbal admonishments to rein in lending, especially to property developers, proved ineffective. So on August 23rd the central bank raised its reserve requirements for financial institutions from 6% to 7%, forcing banks to keep more money on deposit with it. The PBOC estimates that this move will drain 150 billion yuan from the banking system, checking lending and thus preventing another build-up of bad loans. In China’s financial system, says Nicholas Lardy of the Institute for International Economics in Washington, DC, 31.4% of loans—equivalent to 44.6% of GDP—were non-performing at the end of 2002.

This is a lose-lose situation. If the Chinese gov’t is serious about cooling their economy, a next logical step is to revalue the yuan against the dollar (i.e. make the yuan stronger/dollar weaker). This will have serious economic repercussions, a lot of them negative, especially if the revaluation isn’t managed extremely well. My prediction is that a revaluation that’s even slightly sloppy will usher in a period of significant volatility in the international financial world, as well as in US asset (i.e. stock and bond) markets.

On the other hand, if there is a banking-sector meltdown in China, then the Chinese gov’t will not want to revalue (the cheap yuan keeps exports growing), but the Chinese economy could then be in for some serious trouble more generally. China is now the world’s third largest economy after the U.S. and Japan, so if China’s economy goes, the rest of Asia will go, and this will be a big problem for the world economy.

One bit of history: the last time the Chinese changed their exchange rate was in 1994. Within three years this had lead, more or less directly, to the East Asian financial crisis. I’m not saying that the sky is falling… but I would definitely advise you to keep your eyes on this issue over the next year. By the way, when the Chinese DO revalue the yuan, expect interest rates in the U.S. to take a pretty serious step up.

Kash