China beats US in currency game

You have to hand it to China. When it comes to managing both domestic economic policy and international policy wrangles, the country has tended to knock the spots off supposed experts in the West.

Take the latest moves over the renminbi (RMB). In the US, the newsflow had Congressmen getting increasingly agitated over the perceived under-valuation of the Chinese currency.

There was the verbal equivalent of saber-rattling: China would have to revalue the RMB soon, otherwise there would be consequences in the form of protectionist trade barriers. The initial Chinese reaction? "Get off our case". Roll back just a month and all the rhetoric coming out of Beijing was that the US had no business dictating any aspect of economic policy to China. Various comments from Chinese officials were widely read as an overt warning to keep the RMB off the agenda at the approaching G20 summit in Toronto.

But what does China actually do as the G20 summit gets closer?

It suddenly re-values the RMB, breaking its existing peg with the dollar, moving the currency marginally higher.

Imagine all the hot air that was being manufactured in Washington, ready for the Toronto meeting. It's all gone to waste. But did China simply cave in to American pressure here?

Not a bit of it. China revalued to help cool its own economy on the inflation front – something the US could only dream of – while simultaneously boosting domestic consumption with cheaper imports.

This was a near perfect policy adjustment based on Chinese economic necessities rather than American political demands.

Oh, and it also had the political advantage of blunting all but the most aggressive attacks this weekend in Toronto.

But where does this take us?

The equity strategy team at Credit Suisse (CS) in London, led by Andrew Garthwaite, have some thoughts.

The CS team would not be surprised to see the RMB appreciate by more than five per cent against the US dollar over the next 12 months, especially given that: "Last time the RMB revalued (July 2005), it appreciated two per cent immediately and then by 20 per cent over the following three years against the dollar (but anaccelerating rate one year after the revaluation).

"The RMB is nearly 50 per cent undervalued according to our FX team's model (China should be running a current account deficit of three per cent of GDP in equilibrium, yet it is running a surplus of 5.5 per cent of GDP).

"It helps control overheating (each 10 per cent RMB takes one per cent off inflation). Our China economist, Dong Tao, expects inflation to rise from 3.1 per cent currently to 5.5 per cent by the year-end. It is noticeable that last week the Ministry of Human Resources and Social Security highlighted that there is now for the first time since the survey started (in 2001) a labour shortage in China.

"It reduces the threat of punitive tariffs: particularly from US senator Charles Schumer (one of the most powerful Democrats in the Senate)."

But none of this is likely to happen very quickly. China has to manage the fact that too rapid an adjustment of its currency could be very disruptive internally.

A key reason for this is that a large portion of its exporting sector survives on low-profit margins. State-owned exporters, for example, operate at just three per cent margins, so a rising currency will hit them hard and quickly. There's also the matter of China wanting to control the amount of so-called hot money that flows into China itself. A rising currency encourages that and risks inflating local asset bubbles, such as in property.

But it also cuts the cost of imports and this would seem to be the important secular trend to focus on in the medium term.

What we are quietly witnessing is a rebalancing of the impetus for global economic growth away from the American consumer to consumers in China and other emerging nations. As CS point out, the consumer share of GDP in China is very low at 32 per cent – compared to 71 per cent in the US. With a stronger RMB, Chinese consumers just got a boost to their purchasing power.

With their command economy approach, China has been working for years to try and convince people to spend more.

For a long time, for example, in the major cities it was common for the local authorities to send the workers out for a day's shopping. Managing its currency upwards has a similar effect.

But there are risks with this approach – the largest of which is the danger that a stronger RMB will create inflationary bubbles at home. Some people already believe China is suffering a property blow-out that might cripple its banks.

Time will tell, but for now China has a set of "problems" that American policy makers could only dream of.

- Paul Murphy is associate editor of The Financial Times. The views expressed here are his own