The Chinese Dragon Breathes Fire

The Chinese economy has grown at its fastest rate in 12 years during the second quarter. China’s GDP growth has increased to 11.9 percent from a year ago. This figure has exceeded all expectations from 23 economists at Bloomberg. Inflation has risen to 4.4 percent in June, the fastest rate since September 2004. The Chinese economy is on fire and needs cooling. The most obvious is a change in monetary policy. There is much speculation the Chinese central bank will increase interest rates and in turn this will strengthen the yuan. But is revaluation by direct policy of the yuan needed?

According to Glen Maguire, chief Asia economist at Societe Generale SA, a strict revaluation by the central bank is needed in order to quell the surge. He indicates the yuan may even need to appreciate as much as 3.5 percent in a single day. A stronger yuan would slow down the economy by making exports more expensive and thereby reducing China’s enormous trade surplus. U.S. lawmakers have been very keen on a strengthened yuan, claiming that U.S. companies have been taking hits by its artificially low value. Senator Charles Grassly has spoken on the issue extensively stating the Chinese currency has not risen fast enough.

Despite U.S. and Chinese economists having met and agreeing on the same direction for the yuan, the Chinese central bank does not want a fast acceleration. Bank of China Governor Zhou Xiaochuan has stated he does not want the yuan to accelerate nearly as fast as the U.S. would prefer. Other currency analysts do not see the yuan appreciating to unprecedented levels anytime soon. According to Tim Shea, a currency analyst in the Sales and Trading Department at FXCM, “China has shown since the initial dropping of the peg in 2005 that the strengthening of the yuan would happen gradually and at their own pace.” He points out, “…that a 3 percent change in one day would be a move of 2200 pips, the equivalent of all the movement made since January. This would not be in line with past policy.”

We have also seen changes in Chinese fiscal policy to help the cooling process. Inflation has actually outpaced the return on bank deposits spurring investments in the equities market. The benchmark CSI 300 stock index for the Chinese market has gained 87 percent this year. In response, fiscal measures have included legislation allowing the 20 percent tax on interest income to be reduced or even taken away. As a result, fixed-income investments have increased to 26.7 percent in the first half of the year from a year ago. Even though this increase in savings is modest in comparison to the spurring equity run, a future meltdown of the Chinese economy is unlikely. With the right fiscal and monetary policy the Chinese economy will continue to grow at a controllable pace. The yuan will strengthen, but most likely at a pace unsuitable to U.S. lawmakers.