China faces challenges on currency
(Los Angeles Times)
Updated: 2005-07-25 15:48

China's move this week to reform its currency system set the nation on a path to greater financial independence and stronger integration with global markets. It also marked a milestone in China's dramatic rise from a poor communist state to a powerful force in the world economy.

But the shift also creates new challenges for a country already facing mounting domestic and foreign pressures, largely resulting from its booming growth.

At home, China is trying to slow an economy that some fear has become overheated as steel plants keep popping up and real estate prices reach bubble levels. It has to clean up massive problems with its shaky banking system and inefficient state-owned companies, while facing growing unrest from millions of impoverished people as income disparities widen and unemployment remains high.

The country's rising wages and pension costs, along with transportation bottlenecks and energy shortages, also are prompting foreign companies to consider shifting production to other countries. Many manufacturers already operate on very thin profit margins.

Externally, China still faces pressure from the United States and other countries that want Beijing to further reform its economy and eliminate allegedly unfair trade practices. Although China's currency reform was lauded by prominent American officials, including U.S. Treasury Secretary John W. Snow and Federal Reserve Chairman Alan Greenspan, the Chinese were only partly successful in easing tensions with the United States.

Meanwhile, currencies of other Asian nations, which are intertwined with the yuan, are rising sharply on the news. Those nations might also exert pressure if their pricier currencies hurt their economies by making their exports more expensive abroad.

Chinese leaders, undoubtedly mindful of these challenges, nudged up the value of the yuan only 2% and put in place a deliberately ambiguous mechanism that will give them strong control over the currency.

Still, "China is headed down the road to allowing the markets to hold more power — and the bureaucrats less," said Donald Straszheim, an economist and chairman of Straszheim Global Advisors in Los Angeles.

Though he and many others view China's currency change as good for the Chinese and the world, the road is still likely to be bumpy.

By changing their currency policy from a decade-old peg to the U.S. dollar to a more flexible system, Chinese policymakers hope to gain more instruments to help manage their economy. For example, the new system may allow greater use of interest rates to slow growth.

One of the biggest concerns is whether China's revaluation will increase speculation from investors and currency traders expecting further appreciation in the yuan. Their actions could spur even faster economic growth while driving up inflation, risking further instability.

The flow of so-called hot money from speculators slowed in recent months, from an estimated $55 billion in the fourth quarter of 2004 to $13 billion in the second quarter of this year, said Tim Condon, chief Asia economist in Singapore for financial firm ING. Those funds supported excessive building of factories and homes. Now, with the currency revaluation, there could be another wave of capital inflows, analysts say.

Chinese officials already have taken measures to cool the property market, imposing capital gains taxes in some cities and stricter lending guidelines. And officials Friday sought to chill speculative activity from heating up again.

"Expectations for a bigger appreciation of the yuan's value was, and will be, unrealistic," the official China Daily newspaper said in an editorial.

Nonetheless, as China watchers point out, now that the yuan has been revalued and linked to a range of international currencies beyond the dollar, Beijing may not be able to withstand pressure from speculators.

"It is simply unsustainable for government to retain control over such a globalized market in the face of massive unbridled speculative forces," said Tony Hughes, a China expert at Economy.com's office in Sydney.

Beijing in recent years resisted pressure from Washington to revalue and move to a more free-floating currency, partly because China needed to modernize its financial system and reduce the heavy volume of bad debts.

The Chinese have made some progress, but analyst Straszheim notes that many older Chinese officials just don't understand capitalism.

Perhaps the biggest single concern to Beijing, though, is rising unemployment, as millions of workers have been displaced from state-owned enterprises but cannot easily find work in factories or in the cities. The change in currency policy heightens the risk of further joblessness and business closures, particularly at export companies that have been the backbone of China's economic rise.

Take the case of Tao Qiang. The 33-year-old export manager at Weihai Textile Group in Shandong province on Friday was forced to raise prices on his coats, jackets and sweaters, reflecting the 2% rise in the yuan. If his customers balk at steeper price tags, Tao fears it may force him to reduce production, cut wages and possibly lay off workers.

If policymakers raise the yuan 5% more over the next year, as some analysts expect, Tao says it could be devastating.

Some orders are already shifting to Southeast Asia and Mexico, where there are no tariffs or quotas, he said.

"If the yuan keeps appreciating, this will inevitably keep happening and many factories around here might close."

On the other hand, a stronger yuan will enable China and some companies to buy goods for less, notably oil and other natural resources and raw materials. Chen Ying, chief financial officer of Baosteel Group, China's largest steel producer, said his firm would benefit from an appreciating yuan.

"Our raw materials are 100% imported, as are some of our equipment," he said. There's little downside, he added, because exports account for just 10% of Baosteel's business.

Even before the currency appreciation, profits at many Chinese export manufacturing companies were already squeezed.

Shenzhen Textile Co. is one of them. For each dollar of sales, the company's profit is a mere eight-tenths of a penny, said Zheng Yi, the company's financial department manager.

"It will definitely affect our business," Zheng said.

(courtesy of the Los Angeles Times)

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