Politics and economics point to devaluation of the yuan

BY NEIL A. MARTIN

Like China's Great Wall, its currency, the yuan, has stood firm while currencies around the globe have fallen like so many dominoes, starting with Thailand's baht in mid-1997 and continuing to the Russian ruble last week.

But notwithstanding official denials, China is likely to follow the same path, bringing the Hong Kong dollar along with it. And the decision will be motivated as much by politics as by economics.

China, unlike Russia and most other victims of the Asian flu, does not exhibit the same symptoms of a crumbling domestic financial system and a heavy dependence on foreign hot money, which have sent currencies reeling as much as 82% in the case of the Indonesian rupiah. Part of China's immunity reflects its still-large trade surplus ( $26.7 billion for the seven months to the end of July ) and huge foreign-exchange reserves of $140 billion. And it also owes much to the fact that the yuan ( also called the remnimbi ) is not fully convertible into other currencies. Nevertheless, the yuan's value in the black markets on the streets of Shanghai, Beijing and other major cities fell about 10% following the recent devaluation of Vietnam's currency, the dong.

According to one foreign analyst in Shanghai, the city's black market is still bustling with illegal currency dealings with the yuan trading at around 9.0 to the dollar, versus the official rate of 8.27, and would weaken further in the weeks ahead. Chinese companies with overseas operations also reportedly are refusing to repatriate foreign earnings for fear of an imminent yuan devaluation. Others reportedly are sneaking dollars out of the country to European banks through Hong Kong. A recent report by ING Barings' Hong Kong office noted an unexplained $400 million drop in China's foreign exchange reserves at the end of June. Given the trade surplus and direct foreign investment, the report notes, simple arithmetic would suggest that $30 billion leaked out of the country in the first half, the most since 1978.

There are all kinds of reports and rumors about dollar hoarding and capital flight that are keeping devaluation fears alive and the money changers busy, the Shanghai analyst says. People are really convinced the yuan is going to be devalued. And so they should be. Despite repeated promises by Chinese authorities not to devalue their currency, a growing number of foreign analysts and China watchers believe they will have little choice if the country's economy -- and exports, which account for about 20% of China's gross domestic product -- continue to deteriorate. They predict that a combination of international and domestic pressures, ranging from the impact of Japan's weakening yen to rising unemployment in China, will force Beijing to devalue its currency by 15%-20% within the next six months.

China's between a rock and a hard place, says Michael J. Taylor, chief economist with Indosuez W.I. Carr in Hong Kong, who is predicting a 20% devaluation by January. It needs a healthy export sector to help finance its reform program, keep the economy humming and absorb the increasing unemployment created by the shutdown of state-owned enterprises, he explains. But unfortunately, Chinese companies are operating in a deflationary global environment in which they have to run just to stand still and maintain current market share.

It is not so much whether or not to devalue but how to keep enough growth in the economy to prevent unemployment from getting worse and to avoid undermining social stability, says Albert Edwards, global strategist with Dresdner Kleinwort Benson in London. They are acutely aware of the Romanian model of political-economic transition, he quips, referring to the 1989 execution of Nicolae Ceausescu, Romania's president during the collapse of communism in Eastern Europe in the late 1980s. If growth is insufficient to keep them in power, they will start pulling out all the levers, including devaluation.

As if to underscore this, media reports recently quoted the head of China's largest shipbuilder, Dalian New Shipyard, as saying that at least a 20% devaluation would be necessary for exporters like his company to

maintain employment and remain competitive in international markets. Barring that, the alternative, he warned, would be a risk of worker unrest and economic instability. China last devalued its currency in January 1994, when it ended its dual system for domestic and international transactions. The yuan immediately slipped by 33% against the dollar and within nine months declined by 50%, but has remained fixed ever since. China's Premier Zhu Rongji was the country's chief economic planner at that time, and analysts say he well remembers the sharp boost to industrial production and exports that followed that devaluation.

China's economy today is in the grips of deflation; retail sales were down 3.25% in the 12 months ended June and industrial production is declining. Most analysts forecast economic growth of 6%-7% this year,

well below the government's 8% target, and warn that it could slump as low as 5% from last year's 8.8% pace.

But those seemingly robust numbers obscure the economy's difficulties. Much of production is piling up as inventories. More than half the country's state enterprises are unprofitable and many more are debt-ridden, but are being kept alive to provide jobs. Still, unemployment is rising rapidly, and in some regions may be twice the 20% level generally acknowledged for China as a whole. That's even before the current disastrous floods.

While Chinese officials say they wouldn't devalue unless the yen were to continue to weaken, Japan's current situation provides little confidence on that score. With the Japanese government still apparently unable to come to grips with the nation's banking crisis and ongoing recession, consensus forecasts call for further weakening of the yen, to 160 to the dollar by year-end and to 170 next year, from 143 at present, itself a decline of over 20% in the past year. Beijing cast a no-confidence vote

by dumping a significant portion of its yen foreign-exchange reserves -- right around the time it was exhorting Washington and Tokyo to prop up the Japanese currency.

Naturally, any devaluation of the yuan would raise questions about its sister currency, the Hong Kong dollar, whose value is fixed versus the U.S. dollar. Some analysts believe the impact on currencies and stock

markets in the region would be minimal, arguing that both are already at rock-bottom levels. Markets in the region seem to have already priced that in to their valuations, says Gregory Fossedal, president of the

Emerging Markets Group, a research and investment-management firm based in Arlington, Va. But Hong Kong is a different question, he continues.

Fundamentals will bring pressure on the peg, but monetary authorities will try to hold out, which may not necessarily be the best strategy.

Even more disturbing are fears that China's continuing economic problems could force a premature end to Beijing's schizophrenic one country, two systems policy that tries to package communism and democracy,

free-market and planned economics in a single state. Some critics have long argued this was a ploy by Beijing to allay Western fears about the future of the former British colony after it was returned to China in July 1997. If there is anything that we know will never happen in China, or anywhere else in the world for that matter, it is 'one country, two systems,' says Emerging Markets' Fossedal.

That would hold equally for currencies as well as politics.

Since I doubt you know anyone with a portable gravitometer sufficiently sensitive for this, there is something else called the 'Colma' effect during a total or nearly total solar eclipse. It is a Moire' - like wave pattern that the shadow of the moon makes on the earth during an eclipse -- the closer to total the better. If you actually see this, you are seeing something unexplainable by any conventional ( classical ) concept of gravity I know of. I cannot tell you what this means, if it really exists, but it will set classical gravitational phsyics on its ear.

G'Nite all!

If a default occured in the private sector, the government could control both long term and short term rates with some success.

But now, our government in its infinite wisdom offers few securities with long term expiration dates, so the 30 year rate is pretty much left to the private sector. And -- this part could be dramatically affected by defaults, regardless of the interest rate offered. Just imagine the effects of a plummeting world wide credit rating. I would guess that long term corporate bond rates would then go up -- and not down. The buyer would then choose between the low return 'quality' bonds of the US government, and the high return 'junk' bonds of the corporate sector.

I wonder -- I'll bet that most of the current demand for US treasuries is short term only. Investors may be wary in buying cheap long-term US treasuries in a country that has corporate bonds perceived to be at risk for default.

When I think about all this, I look at our cat, and think -- yes ignorance leads to a peaceful life -- but only as long as someone knowledgable is looking out for that cat. And -- then I do not feel so worried thinking about the future.