The need for money inflow sterilization brings up the key subject of how a command economy works compared to a free-market economy. No one doubts China’s commitment to reform its institutions and practices to the free-market model, but it certainly is not “there” yet.
In a command economy, the government tells the banks the interest rate that can be paid on deposits and what interest rate can be charged for loans. Because nearly all businesses are state owned, including the banks, this has the effect of allocating capital in an arbitrary manner instead of according to competitive advantages. On a practical level, command interest rates do not reflect true supply and demand for funds. If you are a money-market trader with a global reach, you are indifferent between depositing your funds in Country A(the home country) at 5 percent, or Country B at a 10 percent with a 5 percent discount on the forward exchange rate back to Country A’s currency.
The “covered interest arbitrage” is perfect — the trader has no monetary advantage in “swapping” his funds to Country B.
But if Country B offers 10.5-percent interest and the same 5-percent discount on the forward exchange rate, the trader will obviously prefer Country B. Similarly, if Country B offers 10 percent but only a 4.5 percent discount on the forward exchange rate to get back into the home country currency, he gets a 0.5-percent advantage in placing the money there.
In practice, the 0.5-percent advantage never exists. If it did, it would be arbitraged away in minutes. Forward exchange rates always reflect, almost to the penny, the interest-rate differential between the two countries competing for deposits.
When the forward foreign exchange rate is off by a bit, like the 0.5 percent in the preceding example, cash will flow into the country with the higher interest rate or “deficient” forward rate. This is exactly what is happening in China, albeit in a limited way. The official forward rate is limited to about 4- to 7 percent discount off the pegged rate. It is not a true market-set forward rate (although it has many participants) because not all parties have true access to the deposit market. In the absence of access to the deposit market, the forward rate is artificial. In fact, the renminbi forward rate is “non-deliverable,” in the sense that when the forward contract matures, you do not take actual delivery of the currency in your checking account. Instead, you get the difference in dollars between the spot price and the forward price.
To have a true floating exchange rate, China would need true floating deposit rates that reflect supply and demand. However, China is unwilling to institute floating interest rates because its banking sector is overwhelmed with bad loans to state enterprises (possibly as much as 50 percent of their total asset base, according to the ratings agencies), not to mention bank-management incompetence and corruption.
China raised the official one-year lending rate by 0.27 percent to 5.58 percent on Oct. 29, 2004, and it was heralded as embracing market mechanisms. However, this was the first rate change in a decade, and one rate change per decade is hardly an embrace.
Also, in early 2005, China announced a small number of foreign banks and brokers would be allowed to trade the major currency pairs, excluding the renminbi, starting in May 2005. This is supposed to give the Chinese practice in trading freely floating currencies, like dollar/yen, Euro/dollar, and so on. This is disingenuous, too, because throughout history the Chinese have been accomplished traders. It’s hardly likely that they need any practice, although perhaps it might come in handy to know the current back office and bookkeeping practices, including the arithmetic of covered interest arbitrage, or swaps.
According to the March 2005 Bank for International Settlements Quarterly Review (“Trading Asian Currencies,” by Corrinne Ho, Guonan Ma, and Robert N. McCauley; www.bis.org/publ/qtrpdf/r_qt0503e.pdf), average daily trading volume in the renminbi in April 2004 was $992 million. Trading in the non-deliverable forwards was $811 million, while FX swaps accounted for a measly $9 million. (“Swap” refers to the deposit plus forward rate in each country that equilibrates the total return in both countries.)
So how, exactly, would China be able to move to a fully floating exchange rate? It literally cannot. From this we can deduce a floating rate in nowhere in China’s future, and the most we can expect is a change in the “managed float” by some small amount — say, 5 to 10 percent.
Where do analysts get this number? Well, it comes from common sense — small changes work best in command economies, as we learned from big changes that backfired so tragically in Russia — and from the non-deliverable renminbi forward rates. This is bad reasoning, however, because the renminbi forward discount bears no relationship to financial reality and is itself a command-economy number.
During the height of the revaluation talk in April, the one-year non-deliverable renminbi-dollar forward rate widened by 550 points to 4,600 — the largest spread since January, implying a rate of 7.818 Rmb to the dollar in 12 months (a 5.6-percent revaluation from the 8.278 peg).
And what about the timing? Bank of New York’s Michael Woolfolk thinks such a move is not likely until the third quarter at the earliest (when the next Group of Seven [G7] meeting convenes), or possibly ahead of that if it looks as if the U.S. Congress will pass a law imposing punitive tariffs on Chinese exports to the U.S. In other words, the Chinese revaluation is a political event, not a financial or economic one.
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