The yuan?the big known unknown

The current US defence secretary came under much fire, some years before, for the analytical distinction that he chose to draw between the known unknowns and the unknown unknowns. Far from being an infelicitous use of the language, it is actually an important conceptual distinction most people make in their daily lives. But then Secretary Rumsfeld is not exactly wildly popular and the phrase became, for reasons known, rather than unknown, an object of some merriment. Anyway, the big known unknown this year is all about what the Chinese yuan will do and what might come in the wake of this huge movement.

A few days before, we were told the US economy, that great single engine still driving the world, was showing further definitive signs of slowing. In the first quarter of 2005, the US economy grew by 3.1% on an annualised basis, compared to the fourth quarter of 2004. This was short of street expectations, lower than the 4.4% of 2004 and, of course, way lower than the 5% of the first quarter of 2004. The fact of the matter is, the US economy had indeed been slowing ever since the spring of 2004. But there was too much at stake in flat-faced denial, too many billions of dollars of assets under management, for one thing.

The International Monetary Fund (IMF), in its World Economic Outlook (WEO), issued last month, made some of this stuff official. It marked down the 2005 world growth to 4.3%, from the record 5.1% of 2004. It projected US growth at 3.6% for 2005, EU growth at 1.6% and Japan at 0.8%. It also projected a decline in the volume of world trade. Imports into developed economies were expected to grow by 6.5% in 2005, compared to 8.5% in 2004. And exports from developing economies to slow to 9.9% in 2005, from the 13.8% registered in 2004.

The WEO also expects crude oil prices would rise by 23% and non-oil commodities by 4%. And that consumer prices in advanced economies would increase by 2% and that in emerging economies by 5.5%. With four months gone in the year, we already know that crude oil is 12% more expensive than the IMF forecast for the full year and in the US and EU, inflation is toting steady gains.

Has global trade slowed? There seems to be no definitive evidence that it has. US imports continue to grow at a brisk canter. Imports in both, January and February 2005, rose by about 1.7% on a month-on-month basis over the previous month. That is equivalent to 20% growth on an annualised basis. Exports from China have continued to rise fast, though Japan?s exports have barely grown. India, we of course know, has seen slower growth of exports in February and March 2005.

It is nearly 20 years since September 22, 1985, when the Plaza Accord was signed, whereby the US dollar was devalued vis-a-vis the Japanese yen and German deutsch mark. The Plaza Accord itself was an outcome of the Bonn summit of the then G-5, held some months previously. In the February 2005 London summit, the G-8 official website informs us that the finance ministers and central bank governors of the G-7 countries met informally with China?s finance minister and central bank governor to continue the productive dialogue initiated in Washington in October 2004 ?(and)…enjoyed (sic) an open and helpful exchange of views on a wide range of economic issues of mutual interest in a candid way…(including)…the Asian economic outlook, and exchange rate flexibility.? In case the enjoyment was not entirely mutual, or the discussion not candid enough, there is legislation afoot in the US that would impose huge countervailing duties on imports from China, if the yuan is not substantially revalued by the end of July 2005.

History has an odd way of repeating itself. In 1985, the US economy had a current account deficit logging 3.5% of GDP, which was viewed as truly alarming. Following from the Plaza Accord, the Japanese yen gained 33% vis-a-vis the US dollar over the subsequent year. The deutsch mark rose by 28%. By September 1987, both the yen and deutsch mark were 37% stronger than they had been vis-a-vis the US dollar just prior to the Plaza Accord. So what will the Middle Kingdom do? It has been let out that the authorities in China will adopt a more flexible exchange rate, starting from May 1, Labour Day. Which, so ironically, is an American event, the principal export the US made to international socialism. That is, aside from publishing Karl Marx in The New York Times.

To recap, at the start of 1994, China had devalued the yuan vis-a-vis the US dollar by a whopping 50%, from 5.82 to 8.72. It then drifted down, ever so gently, to 8.28 in October 1998 and has been stuck there since. The betting on the street is that China will revalue the yuan by between 5% and 7%, which would take it to between 7.7 and 7.9. The lessons of history, however, indicate otherwise. For starters, the US current account deficit is nearly double of what it was in 1985. There are no Germans around to share the pain. Most other Asian economies have already seen their currencies appreciate and the only thing holding them back from allowing further appreciation has been the obdurate peg on the yuan.

This columnist is, therefore, of the opinion that the yuan will have to go much higher than 7%, may be by as much as 20%, over the next year. Draw your own conclusions about what might then happen to other currencies. Whether that will solve the world?s structural imbalances is an entirely different matter. Note that the rate of personal savings in the US is down to 0.6%. Nevertheless, a substantial realignment of the yuan and the rest of the global currency regime is as good a start as any.

The writer is economic advisor to Icra