The yuan diaries

Analysis: Your guide to understanding the yuan-dollar currency spat

Global Post, April 13, 2010

TAIPEI, TAIWAN -- To get the scoop on China's currency, follow the "hot" money.

So says Shanghai-based independent economist Andy Xie, a highly regarded maverick who used to be Morgan Stanley's chief Asia economist.

Economists like Xie are locked in a fierce debate over the simple question: is the Chinese currency too cheap?

"Hot money" — or speculative foreign money — is the key to the answer, he says.

It's not just an academic tiff. If the currency is too cheap, that means Chinese imports are too cheap on Wal-Mart shelves. That's unfair to competing U.S. firms and means, politically speaking, China's a bad guy.

If the currency is fairly valued, that means Chinese goods at Wal-Mart are fairly valued, too. U.S. firms are just whining and should suck it up. All's fair in love and globalization. By this reasoning, China's just a savvy business rival.

U.S. political pressure was pushing the White House toward the first conclusion. It was about to label China a currency "manipulator" (read: a really bad guy.) But diplomacy appears to have won the day; a decision on that was postponed, and China in turn has hinted it will let its currency rise, at least by an itty-bit. The yuan-dollar level was on the table again Monday, when President Barack Obama met with Chinese President Hu Jintao in Washington.

That's not likely to end the economists' debate, though. To understand that, we first have to unpack a few suitcases of financial jargon.

For those who don't speak "Forex," here's the situation, as explained patiently by Nicholas Lardy, one of America's top go-to guys on China's financial system.

China usually sells a lot more stuff to America than it buys from America. China sells stuff for dollars and buys stuff with China's currency, the yuan or renminbi. That means China's firms end up with way more dollars than yuan. Follow?

The problem is, Chinese firms need yuan to pay their employees and suppliers and buy materials. So what do they do?

They go to China's currency market and swap their dollars for yuan. That creates a lot of demand for yuan. If you remember your Econ 101, a lot of demand should push up the price of the yuan, given a steady supply. In finance-speak, the yuan should "appreciate."

Here's where China's government intervenes. It pumps in extra supply of yuan and sells to all comers, at a roughly set price of 6.8 to the dollar, or about one yuan for 15 cents. "The natural tendency would be for the renminbi to rise," says Lardy. "The government doesn't want that to happen, so it steps into the market and sells the renminbi to keep its value low."

In doing so, China's government collects massive amounts of dollars, mostly U.S. Treasuries, to be more specific. Voila, China's ballooning "foreign reserves," which you've heard so much about. (Beijing's stash is now worth about $2.4 trillion, with $450 billion tucked away in 2009 alone.)

Now back to the debate. Wang Tao, the Beijing-based head of China economic research at investment house UBS, says the fact that China has to sell huge amounts of yuan every day means it's obviously too cheap. If China's central bank overslept one day, the market would drive the value of the yuan higher.

Sounds like an open and shut case. China is creating artificial supply to keep its yuan cheap and so help its exporters. "If the central bank was not buying forex day in and day out, the currency would have appreciated," says Wang.

But here's the catch, counters Xie: A big part of the demand for yuan is artificial, too — that's the "hot money."

Foreign speculators are betting the yuan is going to rise like Amazon.com stock in the 1990s. So they're rushing into China to buy the yuan at 15 cents a pop, hoping to sell it later when the price is, say, 17 cents, pocketing two cents per yuan profit. Sounds like chump change, but it adds up if you're swapping large amounts.

Meanwhile, speculators are parking their yuan in Chinese property. That's driving a massive property bubble, particularly in places like Shanghai. The country's in the grip of a speculative "mania," warns Xie, and "the day of reckoning will come."

He thinks "hot money" accounts for fully half of China's accumulated reserves.

UBS' Wang isn't as worried. She admits some speculators have bet on the yuan, especially since 2007. But she says China still keeps close tabs over foreign money flows, and has many controls. "It's not so easy to get in and out," she says.

That means small speculators may be able to move money back to the home country. But big institutional investors that could really distort China's currency market can't move money in and out of China the way they can in some other countries, says Wang.

Her investment house's latest estimate is that "hot money" accounts for less than 20 percent of China's accumulated reserves, or $480 billion at most.

So who's right?

Ask your nearest economist. And expect to hear three different answers.

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