Why China needs more expensive money

For years now, it has hung like a sword of Damocles over the world's financial community. Governments want to know. So do exporters/importers and investors:

When will China revalue its currency?

It's a simple decision by the Chinese government to let the nation's yuan move upward in value against the United States dollar. China would benefit from cheaper imports and more flexibility in carrying out economic policy.

But if the decisions of central banks seem secretive, the workings of China's decisionmakers are downright mysterious. No one outside its inner circle knows when a revaluation decision might be made. Nor does anybody know what it would mean for the world economy.

But pressures are building.

It takes 8.28 yuan to buy one American dollar. China has kept it at that value for more than a decade by buying up dollars on the foreign exchange market when demand for the dollar is too weak. Most big nations allow their currencies to "float" according to supply and demand in the market for currencies. This has some economic advantages.

"It's something [the Chinese] really have to do at some time," says Romeo Dator, portfolio manager for the U.S. Global Investors China Region Opportunity Fund, based in San Antonio. "But it is a question of when. They would really like to surprise people."

One reason is that the element of surprise helps dampen speculation. For example, foreigners interested in making a quick profit might make a deposit of yuan in a Chinese bank, buy Chinese property, or invest in exotic financial instruments that let them buy or sell future yuans at today's prices. But timing is vital, since yuan deposits pay no interest, real estate is risky, and currency speculation can be costly.

The United States and Europe have been pressuring China to revalue its currency. They see a flood of inexpensive imports from China damaging their firms and costing jobs. In the US, the April employment report showed another 6,000 manufacturing jobs gone.

But the Chinese government doesn't want to be seen as being forced to act by Western pressure. Nor does it want to damage its vital job-creating export industries with a too expensive yuan.

So the guessing game continues.

Edmund Harris, the London-based manager of Guinness Atkinson China & Hong Kong Fund, suggests a 3 to 5 percent increase in the value of the yuan in the next few months. "Getting off the peg is the key trick," he says. But with 3,000 years of history behind it, China "doesn't do sudden shifts in policy."

Mr. Dator has a similar view. He suggests a wider trading band for the yuan, where it would fluctuate between 3 to 7 percent of its present value on foreign exchange markets. At the moment, the yuan would quickly move up in value to the top of the chosen band, he adds.

Neither mutual fund has seen a flood of new money from investors hoping to make a gain from revaluation. Don't look at buying shares in the Guinness fund as "a currency play," says Mr. Harris. Rather, see it as an investment in the fast-growing China region. Some stocks listed on the Hong Kong stock exchange are selling at less than 10 times earnings - cheap by the standards for stocks in the US or Europe, he adds.

David Malpass, chief economist in New York of Bear, Stearns & Co., an investment bank, figures China won't make its move until the fourth quarter, and it will be "very limited" - around 3 percent. In a lengthy report, he cites Wei Benhua, deputy director of China's State Administration for Foreign Exchange as suggesting that a "complete liberalization" of China's foreign-exchange system would take "several decades."

Nonetheless, China may find "it's hard to do a little float," notes Charles McMillion, chief economist of MBG Information Services in Washington, D.C.

When Mexico tried to devalue the peso a little bit in 1994, the peso ended up that year down some 80 percent in value. Devaluations are certainly hard to control. Revaluations - an upward move in a currency's value - are rarer, and may be easier for governments to manage.

Stephen Roach, chief economist of Morgan Stanley, another investment bank, urges China to peg the yuan to a basket of currencies, presumably some European and other currencies as well as the dollar.

The US has a massive imbalance in its current account (its international transactions in trade and some financial investments). So "from the standpoint of stability, [China] is taking on unnecessary risk in tying itself to what could well be the most unstable major economy in the development world ... and the most unstable currency in the world," he adds.

China, he maintains, must tilt the structure of its economy toward more private consumption at home. As it is, exports amount to 36 percent of China's economy, more than three times the 10 percent share in the US.

Nobody seems to expect a modest revaluation to have much impact on Chinese exports or American imports.

Only 10 percent of US imports come from China, notes Dator. So raising the value of the yuan by a few percentage points won't discourage many exports.

It will, however, make China's imports of raw materials, mostly denominated in dollars, a bit cheaper. That will tame Chinese inflation a little. A revaluation, though small, also might ease the political pressures from the West on China.

Some speculate that yuan revaluation could push interest rates higher in the US since China might not need to buy so many US Treasury bonds to keep the yuan steady. But nobody really knows.