The G-7, China and the Fed Jude Wanniski February 10, 2004

Is China about to revalue the yuan? The report in this morning’s New York Times of a “report” in Beijing to that effect seem more credible than ever, despite official denials that it is considering such a move “in the near term.” The influential China BusinessPost, which is government owned, cites officials of the central bank as it source. The report indicates the move may come as early as March and involve a 5% revaluation, with an allowance for as much as another 5% via a broadening of the narrow band the bank has used to keep the yuan pegged at 8.3 to the dollar since 1994. The G-7 meeting of finance ministers last weekend in Boca Raton seemed to nudge China in that direction by urging countries without “flexible” currency regimes to move toward flexibility. China’s is of course the only major economy that rigidly fixes its currency to another’s, in this case the dollar’s. 

Bob Mundell, who happens to be in Beijing for a high-tech exposition, was quoted in Monday’s China Daily< as saying that China should not revalue: "There`s never before in history [been a situation] that international monetary authorities… try to pressure a country with an inconvertible currency to appreciate its currency… Appreciation or floating of the [yuan] would involve a major change in China`s international monetary policy and have important consequences for growth and stability in China and the stability of Asia." This commentary appearing in the China Daily last September 15 made the case for not revaluing the yuan.

Of course, Mundell is right in saying this kind of action is unprecedented insofar as “international monetary are concerned,” but it was the case that President Nixon in 1971 used direct pressure on Japan to revalue the yen as part of the August 15 package that closed the gold window. The package included a surtax of 10% on imported goods, which the Japanese immediately dubbed “the Nixon Shock.” Then as now, the move was aimed at changing the terms of trade between the U.S. and Japan in order to increase employment stateside. The move failed, as Mundell at the time predicted, but the devaluationists kept insisting that the dollar/yen devaluation was just not enough, and another round would produce the desired benefits. This time, though, I think Mundell is wrong, not that there would be “job transfers” from China to the U.S. and Europe with a stronger yuan. That won’t happen. I do think China would benefit in its domestic economy with a yuan repegged at 7.5 to the dollar. The futures market already sees the yuan at 7.9 by year’s end.

As you might expect, the reason has to do with the price of gold in both currencies.  The dollar/gold price at $407 is inflationary terrain given our equilibrium benchmark of $350/oz. The fact that the U.S. debt structure is mature and China’s is not means the implied 15% or so rise in the general price level would take several years to be felt in consumer prices in the U.S. economy, but it is already being felt in the Chinese economy. Where the Federal Reserve now is signaling that it is neutral on whether our monetary condition is inflationary or deflationary, China is worried that its economy now is overheating. We still expect the dollar/gold price to end up 2004 under $400, especially if the Fed bumps up the 1% funds rate at the June FOMC meeting. There also is a good chance Congress will deliver legislation on the Foreign Sales Corporation (FSC) during the next several weeks, to avoid penalties from the World Trade Organization. This also should increase dollar demand, at least holding down the dollar/gold price, and at the same time increasing real asset values on Wall Street – which is what the Fed wants to see in its output gap model before it bumps up the overnight rate.

The danger for China is a dollar that appreciates too sharply over the balance of 2004. Its largely rural economy feels relief with increases in commodity prices from the inflation. If the Fed this year pushes the funds rate to 2%, which is how the eurodollar market is now betting, it would cause serious distress in rural China. The crops farm co-ops have collateralized won’t yield the prices necessary to pay down debt. Beijing would then have to go through another round of bailouts to prevent economic distress from becoming political distress.

It is not too soon to begin worrying about an appreciating dollar when it is still in the inflationary range. A 1% funds rate is no doubt too low and has been the cause of much of the dollar’s weakness in recent months, when 1% became a negative rate. But if gold were to decline because of an increase in the demand for liquidity, a 1% rate would soon be in positive terrain. In his speech last month in Frankfurt, Fed Governor Ben Bernanke recalled how Milton Friedman decades ago had argued that when monetary policy was working best, the rate at which banks borrowed from each other to meet reserve requirements would be close to zero. In a gold standard working as it should, longer-term bonds would yield no more than 3%, but the shortest rates would not have to be above 1% and could approach zero. That’s why the 10-year note is still doing as well as it is, not yet reflecting a 15% inflation. The market has been advised by the Fed that the next moves on funds will be up. Just changing a few words at the recent FOMC meeting was enough to have gold bulls dumping enough on the news to send the price down by almost $25 before it began to inch up again. Fed Chairman Greenspan only has to burp to change expectations in advance of the June meeting, when we should see the economy strong enough to induce a quarter-point move by the FOMC.

Most of the political discussions in Washington still are focused on “the jobless recovery,” with President Bush correctly sticking to his guns that the 2003 tax cuts are producing jobs at long last and will continue to do so in 2004. However, his economic team made the mistake of projecting more jobs in 2003 than showed up in either the payroll or household employment surveys. By promising another 2.5 million jobs by the end of 2004, as he did yesterday, will at least leave him politically vulnerable. The Democrats make themselves even more vulnerable by following the lead of Keynesians such as Paul Krugman of the New York Times, who looks at puny advances in incomes compared to robust advances in profits and figures consumer demand can’t sustain further growth. We seem to be alone in pointing out that in this kind of recovery, with the DJIA 3,000 points higher than it was 11 months ago, households that had to send members searching for work because their stock portfolios had been smashed now can leave the workforce and return to the golf course. We doubt the economy will need another 2.5 million jobs by year’s end, but those coming back to work will be getting higher wages as the lower taxation of capital works its magic. 

* * * * *