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China currency overload { July 2006 } Original Source Link: (May no longer be active)
http://bloomberg.com/apps/news?pid=20601080&sid=aymBP2NUJkJg&refer=asiahttp://bloomberg.com/apps/news?pid=20601080&sid=aymBP2NUJkJg&refer=asia
China May Need Currency Solution to Achieve Slowdown (Update3)
By Nerys Avery
Aug. 21 (Bloomberg) -- China may be running out of options to cool its economy short of allowing a stronger currency after the central bank's fourth effort in less than four months to rein in growth.
The People's Bank of China's decision Aug. 18 to raise interest rates, following its April move and two increases in banks' reserve requirement ratio, won't suffice to cut a surge in spending that threatens to leave the nation with idle factories, falling profits and rising bad loans, economists said.
The latest rate increase ``will have next to no impact on the Chinese economy,'' said Julian Jessop, chief international economist at Capital Economics in London. ``A stronger currency still has an obvious role to play in keeping inflation low and rebalancing the economy towards consumption.''
Economic growth that reached 11.3 percent in the second quarter over the year-earlier period -- the fastest in more than a decade -- has added urgency to Premier Wen Jiabao's campaign to curb lending and investment. Wen on July 26 pledged to make more use of China's year-old currency regime, which allows the yuan to trade as much as a daily 0.3 percent either side of the dollar.
Today the yuan gained 0.11 percent to close at 7.9656 per dollar in Shanghai, the strongest since the 10-year peg to the U.S. currency ended in July 2005. It has risen 1.8 percent since under the new system. Government bonds slumped and stocks closed little changed.
The yuan on Aug. 17 had its biggest gain since the peg ended, rising as much as 0.25 percent against the U.S. currency, two days after a drop that was within 0.01 percent of the daily maximum.
Wider Trading Band
``The central bank is trying to teach the market how to trade the currency,'' said Ben Simpfendorfer, Hong Kong-based China strategist at Royal Bank of Scotland. ``Increasing volatility is a big step towards creating the free market, which the central bank wants to see before allowing faster appreciation.''
Simpfendorfer expects the trading band will be widened to 0.5 percent from the current 0.3 percent ``shortly.''
As China's economy almost doubled in size since 2000, imbalances in its expansion became more pronounced.
Spending on factory expansion, railway construction and power plants jumped an average 26 percent annually in the past three years, almost triple the pace of overall growth, while exports gained an average 33 percent. Growth in retail sales, a proxy for household consumption, averaged 12 percent.
Investment's share of GDP rose to 44 percent in 2004 from 38 percent in 1978 when Deng Xiaoping started free-market reforms, according to the statistics bureau. That compares with an average 21 percent among Organization for Economic Cooperation and Development countries.
Flood of Cash
China's trade surplus tripled to $102 billion in 2005, and reached new monthly records in May, June and July. The widening gap flooded the financial system with cash, providing recently recapitalized banks with a surfeit of funds to dole out for new projects. A stronger yuan would slow exports and make imports cheaper, curbing the trade surplus and inflation.
``The ultimate solution to stemming this liquidity expansion is to increase the flexibility of the yuan,'' said Ha Jiming, chief economist at China International Capital Corp, the nation's largest investment bank.
China's leaders won't allow the yuan to gain rapidly because they fear loss of export jobs, said Robert Hormats, vice chairman of Goldman Sachs Group Inc. in New York. ``They have workers being fired from state enterprises, they have workers coming in from rural areas.''
Nascent Forward Market
Towns and cities must create about 25 million jobs in 2006 for new graduates, migrant workers and employees fired by state- owned companies, the National Development and Reform Commission, the nation's top economic planning agency, said in February. They may only create 11 million, it said.
In addition, China's financial system isn't prepared for big currency swings, said David Bloom, global head of currency strategy at HSBC Holdings Plc in London.
``In the West, companies use forwards or options so they don't get financial dislocation when there's a change in the currency,'' he said. ``The forward market is opening in China, it is developing, but you need to educate companies on the need to hedge.''
Almost three decades of economic reforms have loosened the state's grip on the behavior of companies, individuals and even local authorities, forcing the government to rely on adjusting the cost of money to keep the economy from overheating.
Policy Constraints
Yet China's currency policy forces the People's Bank to use a benchmark interest rate unlike that of most central banks. Commercial lenders aren't allowed to charge rates less than 90 percent of the official one-year lending rate, which has risen in three steps to 6.12 percent from 5.31 percent in October 2004.
The costs for borrowing and lending between the central bank and Chinese commercial banks, the benchmark for monetary policy in most countries, are lower. The yield on one-year central bank bills is 2.80 percent. Having market rates about 3 percentage points lower than comparable rates in the U.S. helps deter speculation on yuan gains, People's Bank Assistant Governor Yi Gang said in February.
The U.S. Federal Reserve carried out 17 quarter-point increases in its overnight target rate in the past two years, to 5.25 percent. The one-year U.S. Libor rate is 5.49 percent.
Private Industry
Local officials often defy central government orders to curb investment as their careers are tied to promoting expansion. State-owned banks including Bank of China have sold shares in Hong Kong and are under pressure to bolster profits and stock prices, making them less inclined to follow government lending guidelines while funding is so cheap.
Private industry accounted for 57 percent of China's non- farm output in 2003, up from 43 percent in 1998, the OECD estimated in September last year.
Non-state companies such as Huawei Technologies Co. and Gome Electrical Appliances Holdings Ltd. now dominate industries including electronics, retailing and textiles, and are funding expansion from retained earnings rather than bank loans, the World Bank said last week. That reduces the effectiveness of lending rate increases.
Bank loans account for less than a fifth of all funds used for investment while retained earnings and other forms of financing account for 70 percent, according to the statistics bureau.
Higher borrowing costs ``are not being effective in slowing down the economy,'' said Jim O'Neill, Goldman's chief economist. ``They need to do more by allowing the currency to strengthen.''
To contact the reporter on this story: Nerys Avery at Navery1@bloomberg.net
Last Updated: August 21, 2006 06:15 EDT
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