A new regime for the renminbi

After so much speculation, China announced a new exchange rate regime on 21 July for the Chinese currency, the renminbi, together with a new exchange rate with the US dollar. However, this move may have less impact than many hope.

As announced by the People's Bank of China (PBoC), the renminbi, or yuan, will be placed under a "managed floating exchange rate regime based on market supply and demand with reference to a basket of currencies" instead of being rigidly pegged to the US dollar as previously the case. The US dollar will be allowed to fluctuate against the RMB within a band of 0.3 percent around a central parity to be published by the PBoC each day, while other currencies will be given their own fluctuation bands.

As part of the move, the exchange rate of the US dollar against the renminbi was adjusted to 8.11 yuan per US dollar, representing a 2.1 percent appreciation of the renminbi compared with the previous exchange rate of 8.28.

As the Chinese authorities no doubt intended, the sudden move came as a surprise to practically everyone. The surprise was important to prevent speculators from exploiting the move.

Not that there was much to exploit. The revaluation by 2.1 percent was minimal, and for those hoping to see a major revaluation to correct global trading imbalances, it would surely have come as a disappointment.

American politicians, who have been pressing China to revalue the renminbi for some time, tried to put a positive spin on the move. "I welcome China's announcement today that it is adopting a more flexible exchange rate regime," Treasury Secretary John Snow said. Senator Charles Schumer, a New York Democrat who had put up a bill to levy a hefty tariff on all Chinese imports, said that "after years of inaction, this step is welcome", but hoped that there would be more to come. Federal Reserve chairman Alan Greenspan said that "it is certainly a good first step".

Those hoping to see more revaluations or a gradual rise in the exchange rate peg -- a crawling peg -- may be disappointed though. The very next day, the China Daily said in an editorial:

Expectation for a bigger appreciation of the yuan's value was, and will be, unrealistic. Exceedingly drastic response to the change could throw China's and many other Asian nation's economy into chaos, which would be bad news for everybody.

It is difficult to say how closely the editorial reflected official views, but it is clear that China has much to fear from a more substantial revaluation. A large revaluation is deflationary, something that China would not want in view of the large number of non-performing loans in the banking system. In addition, China needs fast economic growth to soak up the large number of unemployed and underemployed people that it has, especially in the countryside.

That it moved at all to revalue could possibly partly have been because of the 9.5 percent growth rate reported for the second quarter. That was probably too much for the authorities, especially with fixed asset investment also rising by 25.4 percent in the first half of the year compared to the corresponding period a year earlier, threatening to overheat the Chinese economy.

The attempt to understand Chinese intentions has not been made easier by the fact that the Chinese have not been clear on exactly how they intend to manage the float. This could be a significant fact.

While many have compared the new exchange rate regime with that adopted by Singapore, which is similar, it should also be noted that the latter maintains a separate monetary policy stance whereby it makes a decision on whether to let the exchange rate rise, fall or stay unchanged against the chosen basket of currencies -- a decision that is announced publicly. So far, the PBoC has made no such policy announcement. Some have taken that to mean that it is being opaque. However, it could also mean that it has no intention of changing the overall exchange rate for the foreseeable future.

In fact, the latter would be consistent with statements made earlier by the PBoC -- on 12 July when, in its first quarter monetary policy report, it had said that the "growth of money and credit remained broadly appropriate" -- and on 19 July when the PBoC said: "We will continue to implement a stable and healthy monetary policy and maintain the steady growth of credit." It would also be consistent with what Zhou Xiaochuan, governor of the People's Bank of China, said at a conference of bankers on 23 July: "China's exchange rate reform won't have too much influence on US deficits."

Furthermore, as many have pointed out, a small revaluation by the PBoC may actually tempt speculators to make bets on further revaluation. Assuming that the PBoC has no intention of rewarding speculators, that it actually made only a small revaluation could indicate that it has no intention of making a big one.

In other words, the 2.1 percent revaluation so far could be all there is to it for some time to come. If so, the total economic and financial impact from the PBoC's move on 21 July would be relatively limited.

The action in the financial markets so far indicates that at least some people believe so. On 22 July, the second day of trading after the PBoC announcement, the US dollar rose almost 1 percent against the yen, partially reversing the Japanese currency's rise of more than 2 percent the day before. The US dollar's exchange rates with other Asian currencies like the Singapore dollar also reacted similarly.

Fixed income securities also saw a turnaround. After falling on 21 July on fears that the renminbi revaluation means less buying of US Treasuries by the PBoC, the 10-year note recovered the next day, the yield falling by 6 basis points to 4.22 percent after rising to 4.28 percent the day before.

Perhaps most tellingly, on 22 July, on its first day of trade after the revaluation, the renminbi actually slipped to 8.1111 from its opening of 8.11.

However, even if the total revaluation turns out to be small, the PBoC's move may still be significant. First of all, it may help defuse political tension with the United States -- as the initial reactions from US politicians suggest -- and thus alleviate protectionist pressures. Secondly, with an exchange rate that is managed against a basket of currencies instead of a fixed peg against the US dollar, the renminbi can now move relative to the latter, giving the PBoC more flexibility in managing the exchange rate as well as in conducting monetary policy. Thirdly, the move should be seen as part of a series of moves by China towards the lifting of capital controls and full currency convertibility.

As it is, the PBoC's move has already had an impact on policy beyond China's borders. Immediately after the PBoC's announcement on the new exchange rate regime, Malaysia also announced that it is lifting its peg to the US dollar and moving to a managed float.

US current account deficit may stabilise as economic growth moderates

The United States current account deficit hit a record US$195 billion in the first quarter of 2005. However, the trade deficit has been falling in recent months, giving hope that the current account deficit may be stabilising as the pace of US economic growth moderates over the next few quarters.

While the average trade deficit in the first quarter had been over US$57 billion a month, April and May saw deficits of US$56.9 billion and US$55.3 billion respectively after seasonal adjustments. With rising oil prices, however, many economists think it is likely that the deficit will rise again in coming months.

The long-term trend for the US current account remains a subject of considerable debate. And the substance of much of that debate has been re-directed to the economic policies of the rest of the world rather than within the US itself after then-Federal Reserve governor Ben Bernanke's speech in March in which he said that a "global saving glut" is a reason for the increase in the US current account deficit.

In his speech, Bernanke said that the federal budget deficit is not a major reason for the current account deficit because the latter expanded even when the federal budget was in surplus between 1996 and 2000. Rather, he said that what changed over the past decade or so was a swing in the current account balance of developing countries from a collective deficit to a surplus.

Bernanke suggested that "a key reason for the change in the current account positions of developing countries is the series of financial crises those countries experienced in the past decade or so". These crises encouraged developing countries to build up their foreign reserves as "a buffer against potential capital outflows". In addition, oil exporters have seen their current account surpluses surge as a result of the sharp rise in oil prices.

Some commentators have conveniently seized on Bernanke's speech to conclude that the United States' current account deficit is not its fault. For example, Robert Samuelson wrote in The Washington Post on 27 April: "Whatever the problems, Americans can't fix them."

I think that is jumping to the wrong conclusion.

First of all, Bernanke did say that "reducing the federal budget deficit is still a good idea", just that the effect on the current account deficit is likely to be "relatively modest". He cited a study that indicated that a one-dollar reduction in the federal budget deficit would cause the current account deficit to decline less than 20 cents.

Also, he pointed out that there are industrialised countries that are not experiencing widening current account deficits, namely Germany and Japan, both of which instead saw substantial increases in their current account balances. He thinks that "countries whose current accounts have moved toward deficit have generally experienced substantial housing appreciation and increases in household wealth".

Then consider that the saving glut is not just a developing-country phenomenon but also is present among corporations. A report by economists at J.P. Morgan published in June concluded that "over the past four years the increase in G6 corporate saving has been about five times greater" than in emerging economies.

What the latter two points suggest is that the root cause of the global saving glut is excessive liquidity arising from expansionary monetary policies, and that is something that government regulators are supposed to be able to do something about.

For evidence that monetary policy is a factor, take a look at the chart below. From it, you can see that the US current account deficit generally rises and falls with various indicators of money supply. And money supply as a proportion of GDP, especially zero maturity money (MZM), has risen considerably since the 1990s.


Money supply in the US is regulated by the Federal Reserve, mainly through the federal funds rate. In fact, the next chart shows that there is a direct correlation between the year-on-year change in the current account deficit as a percentage of GDP and the spread between the 10-year US Treasury yield and the federal funds rate.


So far from being absolutely powerless to do anything about the current account deficit, Americans certainly can do something about it. And indeed the Federal Reserve, by raising the target federal funds rate for the past year, has brought the spread between the 10-year Treasury yield and the federal funds rate down to below 100 basis points, and money supply growth has been somewhat flat in recent months. That may yet have an effect on the current account deficit in the coming quarters, if it has not already.

Of course, a flattening yield curve and slowing money supply growth also probably means weaker economic growth. Note that based on the second chart above, to bring about a reduction in the current account deficit, the spread between the 10-year Treasury yield and the federal funds rate would probably have to be negative, and that is definitely not good for GDP growth.

Don't let anybody say that reducing the current account deficit is going to be painless.

Outlook for stocks and bonds may depend on PMI

For all the fears about a slowdown in the global economy, stock markets around the world did not fare too badly in the first half of 2005. And against the expectations of many, neither did bond markets.

It turned out that among the major stock markets, the one in the strongest developed economy -- the United States -- performed the most poorly. Markets in the moribund and much-maligned European economies, on the other hand, performed very well.

	Close at end 2004	Close on 1 July	Percent change
S&P 500	1,211.92	1,194.44	-1.4
Nikkei 225	11,488.76	11,630.13	1.2
FTSE 100	4,814.3	5,161.0	7.2
DAX	4,256.08	4,617.07	8.5
CAC 40	3,821.16	4,269.62	11.7
Hang Seng	14,230.14	14,201.06	-0.2
Straits Times	2,066.14	2,209.95	7.0

Then again, divergence between the performance of an economy and its stock market is hardly uncommon. In fact, many fund managers had been expecting European equities to do well -- or at least better than those in the US. That they proved right shows that going contrarian is not always a good idea.

One asset class where the consensus have not been so fortunate is bonds. Fears of accelerating inflation at the beginning of the year had many investors shunning them. Those fears have turned out to be somewhat misplaced. Inflation globally remains relatively muted.

As a result, long-term bond prices have risen as yields have fallen. US 10-year Treasury yields have fallen from over 4.2 percent at the beginning of the year to just over 4 percent on 1 July, while over the same period, German 10-year bund yields have fallen from about 3.7 percent to below 3.2 percent.

The fall in yields have been all the more remarkable when seen in the light of the Federal Reserve raising its target federal funds rate since the middle of last year. Federal Reserve Alan Greenspan calls the declining yields in the face of his rate hikes a "conundrum", especially when, in his view, the US economy remains robust.

Well, maybe the US economy is not as robust as he thinks. While the US economy has been growing at close to a 4 percent rate over the past few quarters, the Conference Board's index of leading economic indicators for the US has been declining over the past year or so, as has the purchasing managers' index (PMI) monitored by the Institute for Supply Management.

Historically, the 10-year Treasury yield does tend to track the PMI. In fact, so does the spread between the 10-year yield and the federal funds rate. What the latter implies is that the 10-year yield can fall in the face of a rising federal funds rate if the PMI falls fast enough.

The chart below shows the 12-month changes in the PMI, the 10-year Treasury yield and the spread between the 10-year Treasury yield and the federal funds rate over the past two decades.



Having said that, the latest PMI number shows a rise in June to 53.8 from 51.4 in May. The improvement was quite comprehensive. Most of the sub-indices showed increases, with the new orders index in particular surging to 57.2 in June from 51.7 in May.

And the improvement is not just confined to the US. The global PMI rose too -- to 52.4 in June from 51.1 in May. And like for the US, the new orders index rose strongly -- to 54.4 in June from 51.6 in May, its highest level so far in 2005. The rise in the global PMI was supported by improvements in the PMIs for Japan (from 53.5 in May to 54.0 in June), the euro zone (from 48.7 to 49.9), the United Kingdom (from 47.0 to 49.6) and Australia (from 50.5 to 55.2).

Other recent indications of an improvement in the global economy include the findings from the Tankan survey in Japan and the Ifo survey in Germany.

If the economic outlook continues to improve and the PMI continues to rise, we may get the rise in long-term yields that many had expected at the beginning of the year. So it may be good for equities but not for bonds.

Of course, it is a big "if" anyway. Especially with NYMEX light sweet crude oil prices hovering around US$60 a barrel and a Federal Reserve seemingly determined to keep raising interest rates, a continued rebound in the PMI cannot be taken for granted.

Investors should probably keep a close watch on it.

(Update on 7 October 2005: Chart revised to correct error in spread data.)