Kash’s Call #1: China and the Yuan

I’ve gone back and forth on this one a bit, but this is my first prediction: China will maintain the yuan’s peg to the dollar throughout 2004.

Why? The key is China’s banking sector. I know, “the banking sector” sounds like an incredibly boring answer, but for better or worse it’s often the lynchpin of the whole economy. So let me explain. No, there is too much. Let me sum up.

Think of it this way. If China revalues (changes the exchange rate so the yuan is stronger), that will depress exports, reduce inflation, and cause holders of dollar assets in China to take a significant capital loss. On the other hand, if China holds the exchange rate constant, exports continue to boom and inflation rises.

But a bit of inflation is exactly what China wants right now. China has been flirting with deflation for a couple of years, and as fester reminded us yesterday, China now has a potential banking crisis to contend with. China’s banks are groaning under the weight of loans that borrowers can’t repay.

This sounds eerily like the situation in Japan in about 1990 or 1991. To cap off the analogy, note that China is also experiencing a housing market bubble, just like Japan at that time. Japan’s nemesis throughout the 1990s became deflation, which makes banking problems much worse. (It’s easier for borrowers to repay fixed loan amounts when prices – and hence their revenues – are rising rather than falling.)

China’s policymakers are aware of this. That’s why they will welcome some inflation – both to keep out of the deflationary spiral that ensnared Japan, and also to help improve the solvency of their banks. China is under significant pressure to turn its banks around fast, by the way, because according to WTO rules China must open its banking sector up to foreign competition by 2006. A bit of inflation would make the job that much easier. By contrast, a revaluation that causes banks to lose money on their dollar assets would make it that much harder.

One last note: As I already predicted back in August (remember, I get to remind you of those predictions I’ve made that were right), what China does with the yuan has become increasingly important, both politically and economically. That’s why my first 2004 prediction has to do with the value of the yuan. Economic events in China will have a bigger impact on the US than events in any other country. As a result, almost all of my other predictions depend on this one. So I’m going to start off the year guessing that China will hold the yuan where it is.


p.s.: I’m sure lots of you will disagree with me on this one, as well as my other calls; I’m looking forward to finding out why!