The need to adhere to the clear rule for the basket peg - at least internally for PBC

In today's WSJ Op-ed Stanford Professor Ronald McKinnon lamented on China's yielding to unreasonable pressure from US Congress, comparing this to China's yielding to opium import in the 1840s. He listed five "negative comments" on the new basket peg
  1. With the fixed exchange rate now unhinged, the People's Bank of China (PBC) will have to come up with a new anchor or rule that governs monetary policy. None was announced when the PBC let the exchange rate go. Will the PBC institute an internal inflation target? What will be the financial instruments it uses to achieve this target?
  2. Because China's inflation rate had converged to the American level (or slightly less), any substantial sustained appreciation of the RMB (the Americans want 20% to 25%) will drive China into deflation -- preceded by a slowdown in exports, domestic investment, and GDP growth more generally.
  3. If the PBC allows only small appreciations (as with the 2% appreciation announced on July 21) with the threat of more appreciations to follow, then hot money inflows will accelerate. If China attempts further financial liberalization such as interest rate decontrol, open market interest rates in China will be forced toward zero as arbitrageurs bet on a higher future value of the RMB. China is already very close to falling into a zero-interest liquidity trap much like Japan's -- the short-term interbank rate in Shanghai has fallen toward 1%. In a zero-interest liquidity trap, the PBC (like the Bank of Japan before it) would become helpless to combat deflationary pressure.
  4. Any appreciations, whether large and discrete or small and step-by-step, will have no predictable effect on China's trade surplus. The slowdown in economic growth will reduce China's demand for imports even as exports fall so that the effect on its net trade balance is indeterminate.
  5. Because the effect of appreciations on China's trade surplus will be ambiguous, American protectionists will come back again and again to complain that any appreciation is not big enough. So abandoning the "traditional" rate of 8.28 yuan per dollar will, at best, result in only a temporary relaxation of foreign pressure on China.

He also said, "Thanks in large part to pressure from our lawmakers in Washington, China is now in a nebulous no man's land regarding its monetary and exchange rate policies. Instead of clear guidelines with a well-defined monetary anchor, its macro economic decision-making will be ad hoc and anybody's guess - as was (and still is) true for Japan."

He is of course correct in that US pressure has been irrational, and China should not yield to it. He is also correct in his deduction, but only if his assumption that the People's Bank of China (PBC) does not have "a new anchor or rule that governs monetary policy" is true. But PBC does have clear policy kept to themselves, in my view, which is confirmed by Zhou's recent speech. As long as China adheres to the "translucent box" rules to eliminate human decision, and restrains from changing the peg anchor (less than 2.5% p.a.), Professor McKinnon's worries (1-4) should be largely addressed. Therefore, PBC needs to pay attention to Professor McKinnon's comments and go through this check-list daily when managing the basket peg.

As for his point (5), let's hope the collective wisdom of the American people (who are also the consumers), and bright minds such as Professor McKinnon's would together win over the irrational protectionists.

Zhou Xiaochuan's speech

According to HK Media (Ming Pao , Oriental Daily)

Zhou Xiaochuan of PBoC said more technical details on RMB reform will be announced gradually, including
  • New product and feature in China;s forex market (maybe some derivative under capital control, how?)
  • Details of the basket, the principles and mechanism
  • (confirming my understanding of the translucent box) Future adjustment will be carried out strictly based on the basket principles and mechanism, there will not be human intervention in secret

Zhou also reportedly "urged" corporation to use EUR and JPY in trade contract and investment deals.

周小川稱逐步發放匯改信息 (明報 - 中國)

中國人民銀行行長周小川表示,下一步將逐步提供更多人民幣匯率形成機制改革的相關技術信息。 周小川透露,人民幣匯率形成機制改革之信息有一個逐步釋放的過程,下一步將逐步面向專業市場人士提供更多匯改相關技術信息,如外匯市場的新變化和新產品,有關一籃子貨幣的概況、原理和構成原則等。周小川說,傳遞匯改信息要充分考慮市場和公眾的消化吸收能力。

周小川又重申,人民幣匯率初始水平調整,是指在人民幣匯率形成機制改革初始時刻就做一調整,調整水平為百分之二,而非指人民幣匯率調整的幅度是初始的,事後還會有進一步調整。 他強調,今後的人民幣匯率是浮動的,即根據客觀規律發生波動,這種波動變化是由浮動機制所帶來的,而不再是官方對水平的調整。


The Economist: "a fundamental change in the equation, global labor force doubled"

The Economist, is arguably the mass media with the best brains and highest quality reports. Another great reports (and this) in this issue about China. Having read the story of Kim Philby, it makes me wonder whether MI5 has been subsidizing the Economist in hiring these big brains. What I mean is, how can a magazine keep these talent without overrunning its cost?

Among the observations:

  • "China, along with the other emerging giants, India, Brazil and the former Soviet Union, has effectively doubled the global labor force, hugely boosting the world's potential output and hence its future prosperity." -- note how this tie with this observation of "re-introducing labor to replace capex"
  • "China's growth rate is not exceptional compared with previous or current emerging economies in Asia, but China is having a more dramatic effect on the world economy because of two factors: not only does it have a huge, cheap workforce, but its economy is also unusually open to trade. As a result, China's development is not just a powerful driver of global growth; its impact on other economies is also far more pervasive (see article)."
  • "Trying to halt China's growth through protectionist measures, as many American congressmen would like to do, would be a disaster, for it would close off a powerful source of future global prosperity. "
  • "Americans like to slap the “made in China” label on their huge trade deficit. Yet not only is China's forecast current-account surplus of around $100 billion this year only a fraction of America's likely deficit of $800 billion, but, as chart 1 shows, most of the increase in America's trade deficit has come from outside China.
  • "The entry of China's vast army of cheap workers into the international system of production and trade has reduced the bargaining power of workers in developed economies...In America, the pace of growth in real wages has been unusually weak in recent years...this is America's weakest recovery for decades...In most developed countries, wages as a proportion of total national income are currently close to their lowest level for decades."
  • "China's emergence into the world economy has made labour relatively abundant and capital relatively scarce, and so the relative return to capital has risen."
It also said "Another oddity is that, while the prices of most goods are falling, house prices are soaring in many countries. Again, enter the dragon. Cheaper goods from China have made it easier for central banks to achieve their inflation goals without needing to push real interest rates sharply higher. This has encouraged a borrowing binge. The resulting excess liquidity has flowed into the prices of assets, such as homes, rather than into traditional inflation." I am not entirely convinced that the rise of house price is due to the interest rate alone. It probably has something to do with the Balasa-Samuelson effect, when non-tradable goods are bid up by general rise in wealth. In addition, urbanization and hence rise in demand may be the reason behind it. "Double global labor force" may mean "double global housing demand". Even though many of the migrant workers in China are housed in factory dorm bunker beds, they will move out in a few years, bidding up prices in Shenzhen, then Shanghai, Hong Kong. Soon they will find what the Hong Kong immigrants found in Vancouver in the 1980s.


How much would the RMB peg drift

The Economist has an interesting discussion on what the RMB rate should be pegged at.

1. Big Mac index shows RMB is 59% undervalued
2. PPP shows it is roughly 40%
3. Economist using tools like FEER (Fundamental Equilibrium Exchange Rate)said it is 15-25%, with different assumptions some said it is 44% undervalued

Let's not believe any of them, otherwise PPP rate among freely floating currencies (EUR, GBP, JPY, USD) are exactly the same as forex rate. We all know this is not true (the ecnomists call this the Penn effect, with the Bis Mac being the most unconvertible but standized goods.). Market does not rest at the equilibrium point. The further apart the GDP/cap are, the further apart market is from the equilibrium, as we have observed. Capital control and soft environment also enlarge the "quantum" fluctuation.

There is a phenomenological study called BEER (behavioral Equilibrium Exchange Rate), according to Morgan Stanley and Goldman Sachs, RMB is only 5-8% undervalued (after the July 21st reval). I think this is what the rate will drift into in the next 36-48 months.

The duration of my guestimate seems arbitrary. But I have some reason for picking this range. My gut feeling is the annual adjustment in the peg itself should not be larger than 2.5-3%. Because, as cited in my previous post and Andy Xie of Morgan Stanley, the cost for exporters to hedge is around 3%, China needs to discourage this group from hedging on the derivative market. By limiting the annual appreciation, China helps the exporters save them some financial cost, and keep them from joining force with the speculators. Without demand from businesses, speculators are unlikely to succeed.

see excerpt below (for full content see the link at the top of this post)

Precisely wrong
Jun 23rd 2005

China's currency may not be as cheap as is commonly believed

FOR a decade, China's currency, the yuan, has been pegged to the American dollar at a rate of 8.28 yuan per greenback. Quite a lot of people—most vocally, some American politicians—think that the yuan is enormously undervalued, so that Chinese exports have an “unfair” price advantage in global markets. Earlier this year, a bill was introduced into Congress that threatens to impose a tariff of 27.5% on Chinese goods unless the yuan is revalued by the same amount. The Senate finance committee was due to hold hearings on the currency on June 23rd. If the figure of 27.5% sounds too precise to be believed, that's because it is: it is simply the mid-point of a range of estimates of undervaluation (15-40%) of which the bill's sponsors were aware. Estimating a fair value of the yuan is a dauntingly tricky business.
Usually, three pieces of evidence are offered to support the argument that the yuan is far too cheap. First, China has large trade and current-account surpluses. Second, the yuan's trade-weighted exchange rate has declined sharply since the dollar started to drop in 2002. And third, China's foreign-exchange reserves have surged in the past couple of years.

All this may suggest that the Chinese authorities have held the value of the yuan below its market rate. None of it, though, proves that the currency is unfairly cheap. On the first point, although China runs a large trade surplus with America, its total surplus is much smaller because it runs deficits with other countries. In any case, trade does not have to be perfectly balanced to be fair; a surplus may simply reflect differences in national saving and investment rates. On the second point, so what if the yuan's trade-weighted value has fallen since 2002? It rose—and more markedly, at that—between 1994 and 1998. And last, the build-up of reserves is not proof of unfair currency intervention, because much of it is the consequence of flows into China of speculative money betting on a revaluation.
For any discussion of the “fair” value of a currency, that value first has to be defined. The oldest theory for doing this is purchasing-power parity (PPP): the idea that, in the long run, exchange rates should equalise the prices in any two countries of a common basket of tradable goods and services. The Economist's Big Mac index is a crude estimate of how far market exchange rates differ from PPP. Our latest index shows that a Big Mac costs 59% less in China than in America—ie, that the yuan is 59% undervalued against the dollar. More sophisticated estimates of PPP, based on traded goods, imply a smaller figure of around 40%.
A second approach is to estimate the fundamental equilibrium exchange rate (FEER). This is the rate consistent with both external balance (meaning a sustainable current-account balance) and internal balance (ie, full employment with low inflation). Working this out requires some idea of China's sustainable current-account balance. Many economists argue that because China has a relatively high return on capital, it should be a net importer of capital—ie, it should run a current-account deficit, not a surplus as it does now. A study by Virginie Coudert and Cécile Couharde, published earlier this year by CEPII, a French international economics institute, estimates that, if China is assumed to have a sustainable current-account deficit of 1.5% of GDP, then the yuan is 44% undervalued against the dollar. A study last year, by Morris Goldstein, of the Institute for International Economics, in Washington, DC, which uses a similar method, suggested an undervaluation of 15-25%.
Hold on: what about internal balance? A problem with many FEER studies, says Stephen Jen, an economist at Morgan Stanley, is that they assume that China is close to internal balance. That is hard to square with 400m underemployed rural workers waiting to shift into industry. Even if external balance requires a big revaluation, the internal-balance criterion may partially offset this, because a lower exchange rate would help to bring underemployed resources into use. And there is another flaw in the FEER studies. The claim that China should be running a current-account deficit assumes that net capital inflows will continue. But if China liberalised capital flows, these could be reversed as firms and households invested abroad in order to diversify their assets. The sustainable current-account balance might then be a surplus, not a deficit.
Beneath the froth
More fundamentally, Mr Jen is unhappy about defining a currency's fair value as that corresponding to a “sustainable” current-account balance. That is a less useful guide in a world of increasingly mobile capital. He prefers a third method, known as the behavioural equilibrium exchange rate (BEER). Under this method, economists establish which economic variables seem to have determined an exchange rate in the past (as well as having some theoretical basis), and then plug in the current values of those variables to estimate the equilibrium rate.
Econometric tests imply that the most important determinants of the yuan's real exchange rate have been China's productivity growth and budget balances relative to other countries', and its net foreign assets. Using this model, Mr Jen finds that the yuan is currently only 7% undervalued against the dollar. Economists at Goldman Sachs, using a similar approach, reach a similar conclusion: the yuan is 10% too cheap.
Using a range of yardsticks, the International Monetary Fund reckons, like the BEER studies, that it is hard to find strong evidence that the yuan is much undervalued. The uncertainty about fair value explains why the IMF and America's Treasury prefer to say that the yuan needs to become more “flexible” than to call for revaluation outright. It is certainly in China's long-term interest to make its exchange rate more flexible. But calls for a revaluation of 27.5% rest on flimsy foundations. The economics of exchange rates are rarely so simple.

After the RMB Reval

Many discussions on the implications of the RMB revaluation, or better put as "peg-reform", e.g.

  • impact on export price from China is less than 2.1%, because it is only the value-added portion (labor/etc) in China that counts. CPU of a PC, copperwire in a micromotor, energy cost unaffected. Wal-mart is also very likely to absorb the difference (together with its suppliers). Chances are that productivity improvement (scale and experience curve) will be higher that 2.1% before the contract needs to be re-negotiated.
  • Oil price may rise: 1) higher purchase power from China, 2) oil price control in China set in RMB => can afford rise in USD immediately
  • Boost demand in luxury goods as Chinese become more 'affluent', also in China import, Chinese tourism aboard. But impact will be small (2.1%), except for items close to the inflexion point of the S-curve (i.e. the marginal point in affordability for the medium income bracket).
  • Demand in other currencies (EUR, JPY) and related assets increases, corresponding demand in USD decreases
  • Hedging on RMB for exporters has proven to be not worthwhile (HK media interviewed some exporters who hedged at the price of 3% for one-year forward, only to have found that they lost 1% on these bets). They are unlikely to hedge at the derivative market again
  • etc.

But the better discussion are found on today's WSJ by Hubbard

  • "The bigger danger of focusing on currency valuation is that the real question for China is how to promote efficient saving and investment. Improving this efficiency will make China better off--the reason it should be on the minds of Chinese economic officials.Sustained economic growth requires a financial system that promotes efficiency in the allocation of capital, rewarding savers and allowing the most promising entrepreneurs to achieve success. Centrally directed credit allocation can promote high rates of saving, investment and growth for a period of time, but directed credit is no substitute for the market. Japan's stumble in the 1990s as U.S. growth rose tells a cautionary tale of the advantages of a flexible economy with strong financial markets in advancing productivity growth and living standards."

Also is George Melloan's article on Global View: Hold the Cheers for China's Yuan Decision.

  • "Yet it is a good bet that the future of China is now, more than ever before, in the hands of the Chinese people themselves. They are clearly demanding better treatment by the government and party. U.S. policy, in principle, is to not give the Chinese people any reason to regard the U.S. as an enemy.
    It can thus be hoped that the U.S. will not take any further actions that could be blamed if the Chinese miracle suddenly comes to an end and the country plunges into economic turmoil. That could happen if foreign investment drops off and economic growth slackens. You can bet that the Communist Party will be looking for a scapegoat in such circumstances. There is no point in giving plausibility, with no worthwhile purpose, to any claims that the U.S. is trying to derail China's recovery from a dark past."

On July 25th, Bhide and Phelps of Columbia sent their great insights and analysis "Classical Theory vs the Real World" to WSJ. For details refer to the link, only excerpts below

Classical Theory vs. the Real World
Amar Bhide and Edmund Phelps. Wall Street Journal. Jul 25, 2005. pg. A.14

After extensive jaw-boning by the U.S., China has let its currency strengthen by about 2% against the dollar -- its first official appreciation in a decade. The Bank of China said that the move would help "bring exports and imports into balance." Most observers said that the 2% revaluation was an important symbolic step -- the currency would have to appreciate by as much as another 30%.
Should the Bush administration continue to press China for a more substantial revaluation? Would the elimination of China's trade surplus with the U.S. do the U.S. any good? The received wisdom recognizes that U.S. consumers benefit from the subsidy China provides through an undervalued currency; furthermore, that China, in purchasing treasury bills to prevent appreciation of its currency, effectively subsidizes American borrowers by lowering interest rates. But critics claim these gains are more than offset by the inability of U.S. producers to export their goods to China because of the implicit tariff of an undervalued yuan. Moreover, China itself is also believed to be a net loser because its consumers have to pay high prices for imports. Therefore, eliminating the currency distortions that lead to imbalanced trade will benefit both countries.
Unintended consequences however could turn win-win into lose-lose. We fear that substantial yuan revaluations could do more than increase the prices of imported goods and borrowing costs. The expected offsetting benefit of higher exports might not materialize, since China's other trading partners may be better positioned to take advantage of its appreciated currency. Indeed, it is conceivable that if China refrains from accumulating reserves to strengthen its currency, its total purchases from the U.S in the long run may actually be less rather than more. And, from China's perspective the pursuit of balanced trade may in fact hinder its development.
This received wisdom is certainly consistent with classical theories, which abhor trade-surpluses and regard the accumulation of large reserves as a pathology. But as we see it, the classical theories overlook two reasons that can lead to "imbalances" in the trade between a technologically advanced country like the U.S. and a technologically backward country like China in the absence of misguided policies.
-- First, the classical view of the gains from trade sees only the advantages arising from differences in natural endowments. It behooves Britain, where it rains a lot, to focus on rearing sheep and making wool and to let sunny Portugal grow grapes and make port. The comparative advantage of a backward country vis-a-vis its advanced trading partner, however, derives from its lack of know-how. Or more precisely, the comparative advantages of a country like China lie in activities such as making shoes and textiles, where the technology in the U.S. is the most rudimentary. Conversely, whereas the U.S. may have an absolute advantage on every front, its comparative advantage lies in activities where its technology has made the greatest advances, such as 747s and MRIs.
Now, although exporting shoes and textiles and importing goods that require advanced know-how improves living standards in China, it cannot raise them to U.S. standards. One of many reasons is that the costs, broadly defined, of shipping and selling goods across the Pacific limit what can be economically traded. Therefore, long-run development -- as opposed to a one-time gain from opening up the economy to trade -- requires China to acquire advanced know-how.
A trade surplus -- exporting more shoes than it imports 747s -- allows China to pay for this know-how. Moreover, it may be technically or contractually difficult, or economically undesirable, to buy know- how like salami -- on a piecemeal basis. Therefore it may benefit China to save up its surpluses to buy large lumps of know-how in the future, or to make payments on the debts it previously incurred for its know-how purchases. In other words, wide disparities in economic development can engender imbalances borne of constructive rather than misguided mercantilism.
-- Second, classical theories also ignore the ignorance of consumers. When China first opened up to trade, it is likely that the elite in Beijing and Shanghai craved Western goods that had previously been unavailable or unaffordable. But could there have been much pent- up demand for lipstick or shampoos among the collectivized peasants in remote provinces? How many such individuals would even have encountered such products or known how to use them? Marketing campaigns and word of mouth may "Westernize" Chinese consumers; but in the interim, relatively tepid demand for some of the goods in which U.S. producers have a comparative advantage may tilt China's trade balance with the U.S. into a surplus.
The interaction of the two considerations makes it difficult for both countries to formulate sensible policies. In principle, a rational constructive mercantilism is a fine strategy for China: If underdeveloped financial markets and weak institutions preclude the accumulation of the funds necessary to purchase advanced know-how, it may be desirable for China's central bank to maintain an exchange rate that generates surpluses and invest that surplus in dollar reserves. But the unfamiliarity of Chinese consumers with Western goods, which also dampens imports, may make a deliberate restraint unnecessary or even counter-productive. For instance, China may inadvertently over- restrain imports and accumulate more reserves than it really needs.
For U.S. policy makers, our analysis suggests considerable caution in pushing China to rapidly revalue its currency and stop its accumulation of reserves. It is very difficult for anyone to tell to what degree the large bilateral trade imbalances would respond to policy changes. Our analysis suggests that Chinese consumers have a higher natural propensity to consume goods from countries that are closer to China in their level of development than is the U.S., so exporters from these countries are likely to benefit more from a stronger yuan than are U.S. exporters. Worse yet, from the U.S. point of view, China's accumulation of reserves not only restrains interest rates in the U.S. and the whole world; it also represents a store of funds for future purchases of U.S. goods, services, know-how and companies. What good can it do to drive those funds away where they would be used to bid up the prices of someone else's exports, know-how and shares?
Messrs. Bhide and Phelps are, respectively, professors of business and political economy at Columbia University.


7/22 RMB closing rate: asymmetric intervention?

PBC announced on 7/22/19:21


It also said this is the closing price of the day trade, which seems to be a bit different from my previous interpretation of basket peg recalculation. PBC seems to be monitoring the basket peg in real time, and announce the closing price at the evening, which is some number (based on market trading) within the gap and the recalibrated central parity (in real time)
-- (But more data points needed to understand what they are trying to do)

However, something strange in these numbers
The implied cross XR are:
EUR/USD= 1.2346

Market value at yahoo (10am GMT) shows:
EUR/USD= 1.218

Looks normal, except for the EUR, where the cross rate discrepancy seems larger than normal gap in transaction cost (and wider than 0.3%).

Maybe evidence of asymmetric intervention in USD vs EUR. Wide enough gap for arbitrage. Hard to arbitrage in a capital controlled market. But this may be practiced. If I am a MNC CFO, I have cash in EUR and USD and I need to pay my supplier in RMB, I will definitely use my EUR account to pay for the bill, as it converts to more RMB. Furthermore, if I can convert my USD into EUR with a ask/bid spread less than 2%, I would even convert my USD into EUR before going to PBC.

Now why does PBC allow for such discrepancy?
1) A mistake (looks like the EUR number is from July 20), or a deliberate act to confuse speculators
2) They want more EUR. The current EUR holding falls short of the target weight in their basket. Therefore, instead of buying EUR with their USD in the open market, PBC decided to use the RMB trading board to guide a drift in EUR. By creating a better price for EUR/RMB (effectively depreciated RMB vs EUR), they hope to attract more EUR into their currency board.
  • We can also understand this from another angle. If the basket is 70% USD 30% EUR, they want to sell 8,11RMB for USD0.70 and EUR0.30/1.21. On July 22, more people comes in with USD than EUR (compared to the target mix), so they let EUR/RMB drift away from the target central parity for more than 0.3%, or we could say they recalculated the central parity and allowed it to drift there. Nevertheless, this is an unstable/transitional position as the implied USD/EUR rate is too far away from that in international market.

The Translucent Box: China's RMB "Managed Peg" & Singapore Dollar's "Managed Float"

There are two articles about China's new currency system in the papers, both on the new 'managed float' similar to Singapore's. We see the wide gap in the reporting qualities among the journalists, even though both are from the top media establishment in the world. WSJ, despite its far right editorials, still boast the best in its staff. See for yourself excerpt of WSJ's coverage a thte end of this post, and compare with NYT's in this link (registration needed).
Edited to add: But NYT also has Paul Krugman's excellent article!

The changes comes in with two shifts. 1) the change in the methodology of peg. 2) the revaluation (2.1%). I think it is more important to study the former, while the latter is just a small adjustment conveniently inserted to test the water. It is not even large enough to appease the protectionist in Capitol Hill.

First, let me highlight the key differences and similarities between the RMB and SGD systems (a more thorough discussion by MAS here), a detailed discussion on new RMB basket peg mechanism here
  • Both link to a basket of major currencies, presumable trade related for the respective economy
  • Both have a central parity (determined by the basket) and moving band
  • Both have the basket (hence central parity) concealed from the public -- and adjusted without notification to the public
  • There is no capital control in Singapore, therefore no need to publish the official central parity. Tha band for Singapore is announced semi-annually. Singapore's Monetary Authority will intervene at their own discretion, to maintain the central parity and the band -- In 1997/98 Singapore had to widen its band and it announced to the world, before the semi-annual announcement is due.
  • China chose to publish the "central parity" every evening (needed because they have capital control and RMB is not freely tradable). (Edited to add: in fact, it is not the true central parity that they published. It is the "closing price", which they allowed to veer into based on the results of the basket peg calculation)
  • As a result, China also chose to publish the gap, and make it very narrow (0.3%) (edited to add: Fang Xinghai said on July 27 WSJ that the gap for euro and yen could be more than 0.3%)
  • Singapore cedes control of its interest rate to the market but China is still dictating interest rate (including domestic rate for foreign currencies!), made possible due to its capital control (but perhaps the target of the next step in reform?)
  • A static basket is different from a "crawl". My personal understanding is there is no crawl in a real (static) basket peg, where up of one currency is compensated by down of another. However, since the basket is concealed, the composition may change, hence resulting in an "effective crawl". (of course, 'crawl' also happens when one secretly adjust the peg)
  • PBC said "2. The People's Bank of China will announce the closing price of a foreign currency such as the US dollar traded against the RMB..." Businessweek interprets this statement as "China says each day it will choose one currency from the basket to be the reference currency -- but it apparently won't say which one". (Note in the Chinese announcement it seems to imply the XR for all currencies would be published, literally it means "the closing price the USD and other foreign currencies"). If the English version and Businessweek's interpretation are true. This would result in a crawl as well.
  • China's announcement adds another uncertainty (or arbitrariness) to the mystery, it said it will only "reference" the basket, and may adjust (i.e. over-ride the basket recalculation result) based on demand/supply reality (i.e. market force, including speculative force!). It seems fairly arbitrary and earns China the fame of "black box". The extra flexibility will be rarely exercised and should require high level approval. We can view the change in a basket as another revaluation done quietly.

I think Brasher (NYT) raised a good point about the new system being opaque. I agree an opaque system leaves too much room for the PBC bureaucrats to pull arbitrary strings. My problem with NYT's coverage is that it did not try to really understand the system, nor did it really studied Singapore's or compare the two. Worst still Bradsher probably mis-understood how the new RMB central parity works and has confused the daily gap of 0.3% with the daily recalculation.

I still believe China's new system, although labeled "opaque" by some, is better described as "translucent". Because it is essential still a basket, and one can approximately guess what the basket contains by simple mathematic tools such as multi-variable linear regression. A simple Excel spreadsheet would do the job. The fact that the basket content is concealed is just a way to ward off speculators. Speculators profit from tiny sub-percentage changes through immense leveraging (LTCM's leverage during the Russian crisis is above 1000x, i.e. 0.1% can yield a profit and loss of 100%). The purpose of a "translucent box" is to create an error zone (if one use linear regression) at the sub-percentage point range so that it becomes essentially useless to speculators, while still translucent enough for disciplined management of the float.

So here you are, a translucent box, you know what is going on inside, roughly, but you cannot measure with high precision. This is not uncommon, even in science. In physics, we have Heisenberg's Uncertainty Principles, where your act of measurement interacts with the subject and can potentially influence the results. Here speculators move itself can change the demand/supply and lead to China's over-riding the basket peg temporarily, or not.

Yes, it would be nice if it could be more transparent. But for China's needs, 1) basket to decouple from USD, 2)protection against speculators (hence unpredictability), 3) risk averseness: so needs a proven model, 4) the fact that China still has capital control. I am not sure if there is a better alternative.

The essence of this new change is a fundamental shift in methodology by the Chinese, by decoupling from USD. They will have more room to guide their economy, with less interference from having to maintain a close distance to US interest rates/etc. 2.1% is a gesture. It is not enough to please anybody outside, though still welcomed by even the hardliners in US. The small revaluation (2.1%) serves China as an experiment, to see how much impact on its export, employment and GDP growth. Any impact on Capitol Hill is just a bonus.

What happens in the longer run? Brad Sester said, "Big changes usually happen through a series of smaller steps, and big decisions are taken only after intermediate steps are tried and found wanting. "

below is an excerpt of the excellent coverage by WSJ. For detail see www.wsj.com (subscription),
Currency Decision Marks Small Shift Toward Flexibility;
Move Follows Broader Embrace Of 'Floating Rate' Systems By Developing Countries;
Using Singapore As A Model

Jon E. Hilsenrath and Mary Kissel. Wall Street Journal.
Jul 22, 2005. pg. A.1

China took only a small step away from a rigidly fixed currency system yesterday. But its actions still marked a big step in the 30- year evolution of the global financial system toward more market- driven, flexible exchange rates.

Countries generally choose either a "flexible" policy for their currencies, allowing them to trade freely in often ruthless global financial markets, or a "fixed" approach, keeping the currency stable but losing control of other economic levers like interest rates.

China, mindful that painful tradeoffs come with either approach, is trying to chart a middle path. Using tiny Singapore as its model, it aims to allow some market flexibility while maintaining many government controls. In addition to moving the yuan up a bit, it said it would end the yuan's link to the dollar and instead let it trade in a narrow range tied to a "basket" of currencies -- with details of the currencies and their mix kept secret.

It also promised "greater flexibility," a suggestion that the target the government sets for the currency will be determined, at least in part, "based on market supply and demand."

The move ultimately could set China on a course traveled by many developing countries in recent years. Some 139 countries, most of them small, moved from fixed to flexible exchange rates between 1990 and 2002, according to the International Monetary Fund.


The choice between a fixed-rate system and a flexible-rate system can be unappetizing, since both carry risks. Defending a fixed exchange rate -- under which a currency is set at a predetermined rate -- can force policy makers to push up interest rates to preserve their currency's value and possibly wreck their economies. A flexible exchange rate -- under which a currency's value "floats" against other currencies -- can absorb shocks, but also exposes a country's financial system to speculative attacks and sudden devaluations that can hurt an economy.

Some economists say a middle ground could carry even greater risks, because it opens a country's currency to market forces but leaves officials without all the tools to defend it. China, however, clearly is betting that it is in a position of strength in charting its own course, because of its huge financial resources and, importantly, because of government controls on the movement of capital in and out of the country.


The global currency system has evolved significantly since a system of fixed-exchange rates among major economies was negotiated after World War II. The original goal of the victorious powers was to create a new world economic order that, they hoped, would avoid the chaos that followed the collapse of the gold standard in World War I and exchange-rate turmoil that contributed to the Great Depression. The system, known as Bretton Woods for the New Hampshire resort where it was negotiated, called for the U.S. and Europe to maintain fixed exchange rates, with some flexibility to make adjustments in times of economic crisis, under the watchful eye of the International Monetary Fund.

The Bretton Woods system ran into trouble in the 1960s, in part because U.S. trade deficits mounted and the nation lacked financial reserves to support the currency. It finally came unmoored in 1973, and most major currencies began floating against their counterparts. A number of Europe's major economies surrendered the ability to adjust their currencies against each other with the creation of the transnational euro in 1999. But the euro moves freely in financial markets against the dollar.

Developing countries were slower to make the move. Still, bound to the developed world by trade but often too small to navigate the global financial system safely, many have chosen or been forced to do so. In 1975, 87% of developing countries had some type of pegged exchange rate, according to the IMF. By 1996, the figure was below 50%, and it has continued to fall. Chile, Israel and Poland moved to flexible regimes gradually, while Turkey and Brazil made such moves more abruptly. Hong Kong stands out as an exception: Despite China's move, the Hong Kong dollar remains fixed to the greenback.

"Exchange-rate flexibility is extremely important as the economy keeps opening up," says Ramkishen Rajan, a visiting economics professor at the Lee Kuan Yew School of Public Policy in Singapore. A country with a fixed exchange rate essentially must buy its currency when foreign investors try to sell large amounts, in order to sustain its value. That can drain its foreign-currency reserves -- and push interest rates higher.

China's exchange rate has stayed stable, despite the gobs of capital pouring into the country, only because its central bank has bought billions of U.S. dollar assets, such as U.S. Treasury debt. Chinese technocrats and economic officials around the world saw its approach as unsustainable, in part because buying dollars for yuan made it difficult for China's central bank to manage the supply of credit internally.

China also has avoided another common problem for countries with fixed exchange rates. They usually run into trouble when economic and market conditions argue for a lower value and they can't do what's needed to prop up the currency.

China is in the opposite situation, with a currency that appears undervalued. That's a more comfortable problem to tolerate, but comes with its own share of possible pitfalls, inflation being one of them. China's controls on capital have been important in limiting, though not eliminating, the ability of citizens and speculators to put pressure on its currency, making it easier for the government to manage the currency than it is for countries where capital flows more freely.

Singapore adopted its basket approach in 1981, when memories of oil shortages, stagflation, and exchange rate volatility of the late 1970s remained fresh. It was seen as a halfway house between fixed and flexible currencies.

The advantage of a basket is that a currency isn't pulled way out of whack by sudden market moves, for instance when the dollar moves sharply against the euro, as has been the case recently.

It is known as a "managed float," meaning that the government doesn't let the markets set its value without limit, but doesn't try to maintain a fixed peg either. Especially in a smaller economy, a fixed peg can be broken when speculators bet billions against it, as several Asian countries learned in 1997. China has technically operated a managed float since 1994, but is now expected to allow more flexibility.

Singapore's approach, closely studied by the Chinese in recent months, has been an economic success: Per capita income has risen substantially, inflation has been contained and interest rates have stayed low, encouraging consumers to spend. Despite essentially open borders for goods and capital, authorities have managed to keep the Singapore dollar relatively stable, tolerating a slowly rising trend.

Singapore doesn't reveal exactly how its basket of currencies is constructed, an approach China appears to be emulating. Because they don't know which currencies are in the basket, market participants are kept off-guard, and are reticent to make big bets against the central bank. Slowly, the central bank can edge the exchange rate up or down -- a technique called a "crawl" -- rather than do it in one, big jolt.

While the model has worked well for Singapore, it's less clear that it can work for an economy as large as China's. Singapore's gross domestic product is only half as much as Wal-Mart's annual revenue.

Moreover, because of its smaller size and the government's firm grip on power, Singapore's central bankers have a number of ways besides interest-rate moves to steer the economy that a larger country like China may not. For example, by tinkering with rules on how Singaporeans can use funds in their mandatory pensions accounts, the Monetary Authority of Singapore has in the past influenced prices in the housing market.


How does the new RMB peg work?

Please tune in later as the understanding of how it works is still incomplete. As more data come in we should be able to understand the system better (brown colored = edited after the original blog is posted).
-- most recent update Aug 4th, 2005.

According to Oriental Daily in HK:

This is how I believe the basket peg works. (China's new system may have some twist in implmentation, to ensure continuity, which I will explain later)
  • There will be a basket of currency, maybe around a dozen, including USD, EUR, JPY, HKD, GBP, plus currency of China's other major trading partners.
  • USD will still occupy over 50% of the weight in the new basket, but its weight may be reduced gradually in future ("Cross the River Stone by Stone" (摸着石头过河) ) -- more likely 70%-80% for USD and HKD combined (THB was 88% effectively linked to USD in 1997)
  • Every now and then (maybe daily, hourly or in real time) a new central parity ("medium value" in the gap/band) will be recalculated. Then the trading range will be monitored and controlled at +/- 0.15% around this medium value for USD, with different ranges for other currencies (perhaps 0.5-1% for EUR and JPY). If necessary, PBC will intervene to contain the trading range to within the gap
  • Every evening the closing price will be announced, in theory this will be within range of the the gaps for each currency. PBC said it will use this closing price as the central parity for the next trading day.
  • The precise combination of the basket (or the formula) is not disclosed, as PBC retains the control to adjust or change the basket mix on extreme circumstances (PBC also stressed they only 'reference' a basket formula and they have the discretion to not follow strictly the formula -- see below for discussion)
  • Let's look at a simple example, by assuming the basket is 70% USD, 30% EUR.
  • On July 22 (as announced on July 21 evening), the rate is 1USD=8.11RMB and 1EUR=9.81Rmb (because 1EUR=1.21USD), to get 8.11RMB you need to give PBC USD0.70 and EUR0.30/1.21
  • During the day USD/RMB is allowed to trade at 8.11 +/- 0.012; EUR/RMB at 9.81, and maybe +/- 0.05 -- note the gap for EUR may be larger than 0.3% ("The daily trading price of the US dollar against the RMB in the inter-bank foreign exchange market will continue to be allowed to float within a band of of 0.3 percent around the central parity published by the People's Bank of China, while the trading prices of the non-US dollar currencies against the RMB will be allowed to move within a certain band announced by the People's Bank of China"), we observed from 7/22-8/3 that the EUR and JPY gap to be about 0.5%
  • Recalcuation: PBC will take the spot price of USD and EUR, e.g. if EUR/USD=1.19, then the new central parity for USD/RMB will become 8.11x70%+9.81*/1.19*30%=8.15, new EUR/RMB central parity = 8.15*1.19=9.70
  • The adjusted gap on July 22 will be (roughly) 0.3% from these magic numbers for USD, and maybe 0.5% for JPY and EUR
  • During day trade, PBC will defend the x-rate to the gap (e.g., +/- 0.15% for USD)
  • I would expect China to follow the formula rather strictly. (i.e. the mix of the basket, what spot price to use in the daily recalculation) The fact that they keep the basket content as a mystery (and said they will only "reference" the formula) is just a way to deter speculators away
  • Note that in a basket peg the recalculation is a totally independent concept from the 0.3% gap and one should not confused the two. e.g. the daily adjustment/change can be 3% away from yesterday if that is what the market says (e.g., if USD depreciates vs EUR by 7%, and USD weight is 70%(USD weight):30%(EUR/non USD). then the daily adjustment is 7%/70%x30%=3% so that the basket weighted average is unchanged.)
  • However, the basket content (weight and currency) and the width of each gap will be adjusted periodically. The fact that an adjustment has been done should be announced (Singapore announced the adjustment every 6 months, China is probably still trying to find what would be a suitable relaxation time)
  • People also talk about the "crawl". i.e. When the closing price is assymetrically drifted away from the central parity (because there is a gap), the central parity in the next trading day 'crawls' away from that of the previous day. e.g. if there is a general push for RMB to appreciate, PBC can choose to intervene on USD to keep it in a narrower gap while letting other currencies drift further away (but still within the gap).
  • PBC said "2. The People's Bank of China will announce the closing price of a foreign currency such as the US dollar traded against the RMB in the inter-bank foreign exchange market after the closing of the market on each working day, and will make it the central parity for the trading against the RMB on the following working day." Businessweek interprets this statement as "China says each day it will choose one currency from the basket to be the reference currency -- but it apparently won't say which one". (Note in the Chinese announcement it seems to imply the XR for all currencies would be published, literally it means "the closing price the USD and other foreign currencies").
  • Last note, it should be very straightforward to calculate the basket composition based on the spot rate and the daily announcement. But due to the gap at the anounced closng prices, the error will be about the size of the gaps. If there is indeed a systematic crawl, the regression analysis is made very difficult and even impossible
  • In theory, if there are 12 currencies in the basket, one only needs 12 days of data to solve the simultaneous equation of 12 variables (In fact, there are only 11 degrees of freedoms). i.e., provided we know which 12 currencies are used and the spot price is different enough over these 12 data points (linear independence)
  • In practice, one should use multi-variable regressional analysis
  • It is not difficult to guess what currencies are used (there are only 200 currencies in this world and only about 20 relevant one in this case, many are pegged (therefore, not linear independent) to some major currencies
  • Note the fact that each currency has a different gap means China will be able to influence the cross exchange rate of other currencies

Some additional information I obtained recently, which enabled me to update this post:

  • (Edited to add Jul/23) The above is how an ideal system works. However, there is the problem of continuity. The opening price (central parity) tomorrow may be significantly different from the closing price today. Today (7/22 Friday) PBC announced the central parity for Monday using the word "closing price"(人民币汇率交易收盘价). So it seems they are monitoring the basket central parity during the day, in real time (instead of at end of the trading day as described above). This way the closing price of the day is already within the gap of monitoring, but it is not neccessarily the new central parity. We can at best say the "closing price" is within gap (0.3% error) of the new central parity. It adds a lot more uncertainty when one wants to use regressional to reverse engineer the basket content, and deems speculation effort on this line impractical. -- we will have more insights as more data flow in.
  • (Edited to add Jul/27) Fang Xinghai's "Appreciation Has Its Limit" in WSJ July/27 A12 said (1) a periodic adjustment (of the peg and inside the basket are "critical feature of the new regime") (2) "0.3% against the dollar and ... by even more against the euro and yen" -- seems this is where the crawl mechanism is implemented

Below are the official announcement and the Q&A by PBC. A few points worth noting (english version here)

  • 人民币汇率改革必须坚持主动性、可控性和渐进性的原则
  • 3 principle for this (and future) reform in RMB forex: activeness/preemptiveness (we determine what/when/how ourselves); control (ability to withstand extreme volatitility); progressiveness ("cross the river stone by stone")
  • 中国人民银行将根据市场发育状况和经济金融形势,适时调整汇率浮动区间
  • PBC will adjust the 'region of float' based on market needs. The translation of "region of float" could be the medium value (central parity) announced every evening, it could also mean the 0.3% gap. Literally it translates more closely to the gap. => He Fan's comments that there may be another "baby step": widening the trading band from 0.3% to say 0.5% or 1% in future.
  • However, under this system, there is a limit on how large the gap is, otherwise if EUR/USD rate changes a lot during the trading day, people can exchange USD for EUR before converting into RMB (arbitrage)
  • 参考一篮子货币进行调节 ("The People's Bank of China will make adjustment of the RMB exchange rate band when necessary according to market development as well as the economic and financial situation. The RMB exchange rate will be more flexible based on market condition with reference to a basket of currencies")
  • PBC said it will "Adjust next day's rate by referencing a basket of currency", it did not commit to strictly follow the formula. Although I believe they would still follow the formula very closely. Question is: Would a regular random departure from the formula does any good for PBC?

see also(in Chinese): http://finance.sina.com.cn/roll/20050721/1905220622.shtml


PBC Q&A session: http://finance.sina.com.cn/g/20050721/20151822825.shtml

english version now available here



Smart move, China

China said that as of 7 p.m. (1100 GMT) July 21st it was adjusting the currency's value to 8.11 and tying it to a basket of currencies of China's main trading partners. Smart move.
  1. Decoupling exchange rate from US$, so that the peg reflects the trading mix.
  2. A baby step -- as I have said before, "cross the river stone by stone" (摸着石头过河)-- to test the water, avoid major mistake by seeing the effect before moving further
  3. Discouraged speculator -- as 2% is almost the cost for the leveraged speculator who had started a year ago -- speculating by rolling long RMB is not a profitable position

Going forward.

  1. Less pressure to reval if US$/EUR/JPY rate changed, because it is only the combined weighted average that matter
  2. May continue to have small steps every other year, provided that impact on export/job is proved to be small
  3. If speculators are still active, the changes are going to be small and it will be such that no speculator who longed RMB for over a year (rolling long) would profit significantly

McKinsey's Q&A on China

An excerpt on McKinsey's view on China
For full article see http://www.mckinseyquarterly.com/

What executives are asking about China
The head of McKinsey’s office in China answers the senior executive’s most pressing questions about doing business there.
Gordon R. Orr
The McKinsey Quarterly, 2004 Special Edition : China today

The stability of the banking system, the protection of intellectual property, and adherence to trade commitments are just a few of the long-term issues facing China. They are also the foremost problems in the minds of senior managers of multinational corporations that are already there, contemplating expansion, or considering whether to jump in for the first time; international investors worry about them as well. The following questions and answers, based on McKinsey's experience working with China's government and with Chinese and foreign companies doing business in the country, offer a view of how the country is handling these and other long-term concerns.

What is the condition of China's financial system?
Our view is that most banks are performing much better today than they were a few years ago, although they are carrying massive amounts of bad debt from the days when their primary role was to help maintain employment by supporting state enterprises. Today banks have improved their operating systems and skills, and they have a much stronger risk-management culture.
Indeed, banks are on a strong upward trajectory, and many are quite profitable: in 2003, two of the largest—Industrial and Commercial Bank of China and China Construction Bank—earned operating profits of more than $7 billion and $2.5 billion, respectively. The government-regulated interest-rate spread between deposits and loans gives these banks an enormous margin, one of the largest in the banking world, and they are using it to write off bad debt. Regulators understand the importance of this interest-rate spread, which will remain in place for several years. The potential spread has actually increased this year as banks, for the first time, have been allowed to charge higher rates to riskier customers.
In addition, banks are making money on most of their new commercial loans, though favorable market conditions have helped a great deal—you generally don't see many defaults in an economy growing at 9 percent a year. It remains to be seen whether the improvements in commercial risk management will be robust enough to cope with a weaker economy.
For the big state banks, capital injections to clean up balance sheets before shares are sold to the public also promote the write-off process. Smaller banks are receiving infusions of capital and capabilities from Western investors. Overall, we believe that the chances of a banking crisis are receding.
The real challenge most banks face is the need to prepare for a drastic shift in their sources of profit. Today virtually all profits come from deposit taking and commercial lending. In ten years, retail credit, fee-based activities, and lending to small and midsize enterprises will probably account for about half.
But most Chinese banks have few of the skills needed to compete in these new business areas. They generally lack retail risk-management skills, so the small amount of retail lending undertaken today is generally unprofitable. Some banks are improving their capabilities rapidly and benefiting from foreign capital—Citibank and HSBC, for example, are investing billions of dollars in Chinese financial institutions. But the majority of local banks must do much more to capture the growth available in the market and to compete against international banks that will be able to enter it more freely in 2007 as a result of China's commitments to the World Trade Organization.

Where does China stand on its commitments to the WTO?
December 2004 will mark the third anniversary of China's accession. Over the past three years, the country has moved to meet the core commitments it made at the time of entry, and it is largely on schedule. Nonbank auto finance companies have been established, for example, foreign life insurance companies have been permitted to operate in more cities, retail opportunities have opened up, and regulators act far more transparently. The one major case in which the United States took China to the WTO for violating a resolution—refunds of value-added taxes on semiconductors—was recently resolved. China is also opening itself up much more extensively to foreign agricultural products, including genetically modified ones. Farm exports to China, such as soybeans from the United States and Brazil, are therefore increasing rapidly. What's more, the country is becoming adept at using the WTO rules to its advantage, with about 20 investigations begun last year, mainly against Japan and South Korea.
The financial sector is expected to open up largely as planned, with the major changes coming in 2007, when greater foreign involvement in domestic retail banking will be allowed. Also scheduled for liberalization are the various forms of asset and funds management, but this move is likely to have a less immediate impact, since the subsector is relatively small today.
In a number of instances, different sorts of barriers remain. So, for example, while foreign retailers can establish stores almost anywhere, they must meet local-planning requirements to fit in with a city's financial and development programs. Unfortunately, these requirements are vague and open to subjective implementation.
Also, in several sectors—including telecommunications—the regulatory function still hasn't been fully separated from the government or the operator. The resulting conflicts of interest may hurt competition and, at a minimum, add to the kind of uncertainty that can hold back investors. The Chinese government could enhance its credibility among foreign investors by accelerating the move to more clearly separate regulators and by encouraging them to operate more transparently.
The resolution of the semiconductor dispute suggests that beneath the rhetoric, neither the United States nor China wants to rock the boat
In any case, trade conflicts will continue to arise; the recent conflict over imports of Chinese furniture into the United States is an example. But the resolution of the high-profile semiconductor dispute suggests that beneath the rhetoric, neither country really wants to rock the boat. Although the United States runs a big trade deficit with China, US exports to it have been growing by 30 percent annually since it entered the WTO. Exports from China to the United States rose by almost a third from 2002 to 2003 alone. Trade is also growing strongly between China and the European Union, Japan, and China's neighbors in Southeast Asia.
To what extent are gaps in the protection of intellectual property holding back foreign investment?
At some level, money speaks louder than words. China's $53 billion a year in foreign direct investment suggests that foreign executives find the situation at least manageable, though clearly nothing to celebrate. The core issue is enforcement. The central government has largely followed through on its WTO commitments by creating a stronger policy framework for protecting intellectual property. However, the will and the ability to enforce the policy at the local level are often modest, to the continuing dismay of many foreign investors.
Foreign companies are moving to protect their intellectual property by setting up wholly owned enterprises, now that requirements for joint ventures are diminishing in most sectors. The absence of a partner looking over your shoulder obviously reduces opportunities for infringement but still leaves open the possibility that a product could be duplicated later on. In general, a wholly owned enterprise gives much greater protection for process-based intellectual property than for products.
There are still high-profile examples of intellectual-property theft, such as the copying of a complete foreign-car design. Fake DVDs remain readily available, as do counterfeit golf clubs. And, clearly, in some cases consumers or businesses believe that they are buying legitimate products but actually get poorly performing counterfeit ones. This can damage the image of a brand and remains a big concern, particularly in consumer goods. Procter & Gamble, for example, notes that businesses that actually export counterfeits have sprung up in the past two years.
But as retail channels become more professional, fake products are unlikely to take as large a share of the market as they did in the past. Counterfeit goods are more likely to end up in kiosks or mom-and-pop shops than on the shelves of the Chinese stores owned by the world's largest retailers. The number of intermediaries in the supply chain may even drop to zero, with manufacturers delivering directly to retailers, thereby eliminating the chance of counterfeiting. There is a similar trend in high tech: as Dell's direct-sales model takes off and is copied by others, distributors no longer have opportunities to install fake hardware or software in PCs. Customers—including government departments—that want genuine products with guarantees are learning to buy direct.

What progress have Chinese companies made in improving their corporate governance?
You have to separate the progress made by individual CEOs and CFOs from what's happening at the institutional level. Chinese executives on the whole take their responsibility for having shares publicly listed, particularly internationally, in an incredibly serious way. There is a passionate desire to understand what moves share prices and what motivates investors, as well as a serious commitment to communicating with them through road shows.
At the institutional level, less progress has been made. Strong, dominant personalities run many companies. Although this may help communicate seriousness of intent to foreign investors, these leaders are also prone to make management decisions instinctively, with little input from other senior executives or outside directors. The few independent directors tend to have less weight in corporate governance. A related problem is the issue of capital structure. Many enterprises that were once entirely in government hands have a fairly small free float—for example, 23 percent for China Mobile Communications, 21 percent for China Telecom, and 10 percent for PetroChina. Most of the remaining shares are now in unlisted holding companies ultimately controlled by the central government.
Another challenge related to corporate governance is the growing role of regulatory authorities. The financial sector's regulator, which is considered to be on the leading edge, has become clearer about rules and responsibilities and is increasingly effective in carrying out enforcement. But in energy, power, and telecommunications—where regulators play an important role in other countries—the regulators are less effective and their powers more modest. As a result, companies may put investments on the back burner because of delayed or ambiguous regulatory decisions or a continuing bias in favor of incumbents.
How much progress has China made in restructuring its state-owned enterprises?
Restructuring has advanced more quickly than is generally recognized. The contribution of state-owned enterprises to China's gross domestic product was only 17 percent in 2003, for example. Yet some of the largest state-owned enterprises have become extremely profitable: the energy company PetroChina had operating profits of $12 billion in 2003, while the telecom companies China Mobile and China Telecom made $6 billion and $4 billion, respectively. These companies, operating in infrastructure-based sectors, are world leaders in scale and help offset the losses of state-owned enterprises in declining industrial sectors. Even the basic-materials sector—coal and steel—has undergone a substantial turnaround in profitability during the past few years.
The profitability of these companies provides a financial breathing space the government can use to restructure and shrink underperforming state-owned enterprises. Meanwhile, the process of selling them off and shutting them down continues. Struggling companies tend to operate in relatively deregulated and highly competitive markets where they face both local private and foreign competitors.
A lingering concern is the concentration of declining, money-losing state-owned enterprises in places such as northeast China, where only a limited amount of industry has sprung up to replace lost jobs. Such areas have the greatest potential for social unrest.

Will China's biggest companies become competitive threats outside the country?
Potential global champions from China will come in two forms. First, the domestic giants, including the telephone and oil companies, may well expand internationally, usually on the basis of an infrastructure or license advantage at home. Companies in the telecom sector are already the world's largest in terms of subscribers. They are generating mountains of cash and have increasingly high aspirations, although they currently remain cautious about international expansion because they see it as a high-risk move that few telecom companies anywhere have managed successfully. As for energy and basic-materials companies, their priority is winning access to raw materials, and they are investing, for example, in Africa, Australia, Brazil, and Indonesia. Today they compete or partner with the world's leading resource businesses.
The second type of global champion could come from a more entrepreneurial background: companies formed as a result of intense competition in China's technology and consumer electronics sectors, for example. These companies have typically built strong leadership positions in the Chinese market over the past 10 to 15 years and now face increasingly world-class competition at home from the multinationals.
Companies in this second group have three choices. First, they can expand in China, an approach that requires them to enter new product categories, since they have very high market share in their existing ones. That could be a struggle because they, like companies anywhere, may not have the skills or knowledge to compete in new products, and price competition in many categories is already cutthroat. These companies can also expand internationally in their core product categories, taking on global players head-to-head. Some, such as Haier and TCL, are moving forward, but for most this strategy will take many years to execute, given the need to develop international marketing skills—specifically, branding and distribution. The third, and to most the least appealing, choice is to continue along the present lines and run the risk of becoming, at best, a leading regional player. That's not an attractive option for the ambitious leaders of successful Chinese companies.

As companies look to expand internationally, they face many questions: Should they grow organically? Pursue mergers and acquisitions? Sell branded or unbranded products?
But the biggest challenge these enterprises face is to develop, at the required pace, capable managers with international experience. The current leaders often have a very China-specific background. They know how to win there because they understand local consumers and businesses very well, but that doesn't necessarily equip them to compete in the global market. Identifying and developing qualified people could take a lot of time.

Can China meet its energy and food requirements?
China faces important challenges over the next few years in obtaining sufficient inputs of basic materials to sustain its economic development and to meet the broad needs of its consumers. Other than coal, China isn't rich in most basic materials, and its rising demand has recently driven up the world price of many commodities.
The need for energy sources is an important factor in China's relationships with its neighbors and with lands farther afield. Its growing ties to Central Asian countries, for example, are very much shaped by their energy reserves and by the desire to construct pipelines to its coastal areas. China has historically had close relationships with many African countries, including Sudan, and Chinese oil companies have made substantial investments to develop Africa's oil infrastructure. China's increasingly close ties with the Middle East are highlighted by the start of direct daily flights from Shanghai to Dubai and Doha. As a result of all this, there's little question that multinational oil and gas companies face more competition for access to reserves.
A parallel need is for China to expand its food supply. Urban sprawl is eating up agricultural land at the rate of one percentage point a year. Compounding this pressure is the trend for farmers to switch their production from basic cereals to value-added vegetables or livestock as Chinese consumers eat more meat and fish. Higher incomes in rural areas and the reemergence of price inflation for basic foodstuffs are recent results of this movement.
The country has thus run down its historical cereal reserves and become a major importer of agricultural products. Food imports accounted for about 9 percent of total food consumption in 2003, up from about 7 percent in 1998. Food-exporting nations and their agribusinesses will benefit from growing Chinese demand, while China could increasingly influence world commodity prices as well as consumer prices in the exporters' home countries. Such additional agricultural exports could help undercut the anti-Chinese protectionist sentiment now bubbling up in various countries.


Why RMB revaluation is good for China

Apart from the fact that Chinese workers deserve a long-dued raise and all those reasons widely discussed, another real benefit is the ability to prepare its industries to better compete in a global economy. Let me elaborate below.

By now the leaders in Beijing have already learned that a level playing field is the best way to ensure competitiveness of its industries. Any artificial distortion is going to change the boundary conditions that an enterprise compete in China, and hence also its ability to compete globally.

Today, china has been able to optimize manufacturing cost by de-automation in some areas.
  • "Chinese factories reverse this [automation] process by taking capital out of the production process and reintroducing a greater role for labor. Parts are designed to be made, handled, and assembled manually. This reduces the total capital required by as much as one-third. So output per worker is lower in Chinese factories, but the combination of lower wages and less capital typically raises the return on capital above U.S. factory levels. "

However, this de-automation is done under a distorted labor cost structure. Revaluating RMB will adjust the relative cost of labor and machine to the proper level, hence helping Chinese manufacturers to become more competitive in the long run.

If Chinese enterprises continue to compete under such distorted environment, they will expect the same when they expand abroad and pay heavy price for the lessons. A couple years ago I had the privilege to a casual chat with a senior Chinese official. He expressed that they need to help and direct the value migration of Chinese industry. They were very proud that finally they were able to successfully build the auto industry (and consequently the whole family of support industries such as parts manufacturing, etc.). Meanwhile, they were also concerned about the traffic condition as they obviously could not maintain the same pace of growth in road construction. In the discussion I brought up 2 points to consider:

  • Let's try to quantify the loss in productivity due to extra traffic jam. Workers in Los Angeles loss 30-90 minute per day in traffic compared to other areas in US. Include the impact to environment and energy cost, see if the growth in the auto industry is justified
  • If we allow the auto industry in China to compete on a distorted market environment (e.g. road condition, operating cost structure such as emission standard, etc.). China will eventually find its niche as defined by its own auto market, but such niche would not be the same as in a different market environment such as US or Europe.

Tough choice. But the best option is to evaluate the options objectively with a big picture in mind, try not to discard any seemingly minor detail. Then follow the best strategy as your full analysis recommends.

White elephants: double vision LCD, tailor sized jeans

So many white elephants in the business world, yet the good ideas do not always get the funding they deserve.

I am talking about Sharp's new double vision LCD TV. Neat idea, unrealistic business sense. It has long been known that LCD view is directional. I myself have thought about the 2-angle view idea as well when I was shopping for a LCD monitor 8 years ago. But when you apply this to a TV set, do you expect people wearing headphones? I am not sure if it is a good idea for TV until we find a way to implement directional sound (through polarization filter or other means?). Nevertheless, this being from a Japanese consumer electronic company, down the road they will think about something cool and useful. Kudos to the engineers though.

This reminds me of Levi's internet ordered jeans around 1999. MBAs were fascinated by the idea. I thought it was just a tiny niche fitting the remnants carved out by the standardized size segments. I did not hear about that gimmick much again. Instead, I watch teenagers folding up their oversized jean trunks and they seem to think it looks cool.


Is China a threat? (III)

(I finally squeezed some time to finish the long dued part III of this post, in part prompted by the recent controversy of Maj General Zhu Chenghu's irresponsible comment.)

Continued from Part II...
We have now established the thesis that it is to China's best interest to pursue development under a peaceful international environment, whether China's GDP is below or above that of the US. We have also noticed that such belief resonates strongly with the Chinese leadership, as it is also evidently advocated by Deng Xiaoping himself. More recently, the doctrine of TGYH has been re-iterated, together with a new catch phrase of "Peaceful Development" by the Hu-Wen Leadership, which has replaced the short-lived phrase of "peaceful Rise" upon recommendation from the Foreign ministry and various academics (The Economist).

For those who are still wary of the possibility that the hawk minority in China (e.g. Maj Gen Zhu) might gain control of the country and turn China into an aggressive power, let's examine a few facts, and review a bit of the history. Let's first compare China's situation with that of WWII(aggression by greed) and USSR(exportation of ideology).

The aggression by Germany and Japan in the 1930s were due mainly to economic pressure and thirst for natural resources (esp. In the case of Japan). The world has changed much since then. A world market has formed so that one can use cash (instead of force) to buy up the resources. In China's case, unlike Japan, it is a self sufficient country except for a few items such as energy. Most of the "China threat" advocates have based their hypothesis on one premise: that China will become aggressive when it becomes strong and confident enough. But they have missed the fact that a developed country has no need to become aggressive and too much in stake to get involved in a war, Japan and Germany in 1930s suffered from severe internal economic problems. The aggressions in WWII has their roots in the failure to cope with fast transition into industrialization -- which could be avoided as long as China stick to its gradualism development strategy (Crossing the river by feeling stones, by stones)

As for the comparison with USSR. The communist ideology believes that to achieve the ideal society there will be no private property and no currency. The whole world needs to be brought under the same ideal system in order for it to work. Before that USSR (and PRC prior 1978) have to adopt socialism as a transition stage. As we have all seen in China today, whatever name the CCP call it ("socialism with Chinese characteristic"), there is no longer such global dream of commune, not to mention that communism is no longer mentioned even in party conventions. As the intrinsic global nature of the ideology has been abandoned and exportation of social system has been turned into importation, there is no longer any need to export China's system.

  • One of the key arguments from the "China threat" advocates cite the risk of China's government is not democratically elected, and is therefore "unpredictable". Let me remind them that both Hitler's Germany and to a certain extent Tojo's Japan were democratic countries, while Gorbachev's Russia was not. On the other hand, let's also notice that CCP is a collective leadership today, organized based on Soviet structure of collective leadership and has become more liberal and "collective" in the post-Deng era. Note also that China today in the most capitalistic country in the world by some measures. The party (CCP) still uses the words "communist" or "socialist" because they are the legacy they could not easily change without inviting challenges to their legitimacy to power. The risk of China becoming aggressive is as high as Pakistan or Malaysia gets. I would argue that it is a lot more likely that China goes the Gorbachev way.
  • As discussed in the previous post, the ideology of "forever peace" is now widely accepted by mainstream media and prominent academics in China (e.g., see links in Chinese: Int'l Herald China, quotes of Lee Kuan Yew, Chancellor OF CIEBS Liu Ji and chancellor of CCP University Zheng Bijian, update of Zheng bijian in Foreign Affairs). Liu and Zheng have pointed out a few important facts, including the the points that the only path to lead China to prosperity is to actively maintain peace in the international environment, and the fundamental difference between China and Japan/Germany in terms of intrinsic domestic differences and in international environments in a globalized trade setting.
  • In its 4000 years of recorded history, China has been defending its country by building a Great Wall. Most of the war to the north and to the west of its boundary were a result of securing its border (e.g. war against Hun/Mongolian in the Han and Tang Dynasties). When China expanded most in territory during the Yuan (Mongolia) and Qing (Manchurian)period, China was conquered by neighboring nomad tribes. The expansion was initiated and accomplished by the aggression of these nomad tribes, not the Han Chinese. As soon as these nomads moved into Beijing and assimilated with the Han Chinese culture, their drive for expansion were submerged. The last major war of aggression was the invasion of Korea in the 6th century, for which the Tang Emperor Li Shiming regretted deeply (the only war he was defeated).
  • The reason for the peaceful inclination is mainly due to the influence of Confuciusm, which is pacifist. But more fundamentally, it is due to China's inwardness, with a self sufficient agricultural economy, superior technology, and its arrogance -- Chinese despise their peripheral countries as barbaric. Even sending an official to a border province is viewed as a punishment (Su Shi of Song Dynasty was sent to Hainan)
  • What about Tibet and Taiwan? Let me first clarify that my personal view is that the local people should have the full right to determine their own fate, whether people in Beijing or Washington believe they should belong to China or otherwise. Now let me try to explain PRC's point of view. The current government believes they have inherited these two territories from Qing Empire (ROC of 1911-49 is a transition era in their definition). China's definition of peace is to maintain the status quo, no aggression to the neighbor. Tibet and Taiwan were both within the boundary of status quo to Beijing. It would be absurd if peace means giving up the territory it has effectively controlled for the last 400 years (arguably a brief period of self rule in the case of Tibet). Therefore, China is going to keep Tibet. China's position on Taiwan will not change. But China does not post a threat to the rest of the world or its neighbors just because it inherits Tibet from the Manchurian Empire (Qing). China does not claim any territory of its neighbor, even Mongolia which was also once ruled by Qing. Let's do not confuse geographically confined dispute (within its claimed territory) with aggression/threat (outside its claimed territory)
  • The label of "communist dictatorship": this definition, still used by CIA (see their web-site), is really outdated. First of all, China is not a communist state. It was a socialist state and it no longer is. It is more capitalistic than Hong Kong, or US by some measure, with legacy state owned banks and other assets, and definitely less socialistic that Sweden. More importantly, China has long abandoned the ideology of "communist internationale" since Deng came to power in 1978. This, together with the fading of communism in Eastern Europe and its failure to win the heart of the intellectual youth in the world, means the world is safe from "communist expansion". Finally, as explained above, China is already a social system importer, not an exporter.

There are risks though. For example, in extreme circumstance the hawks might launch a coup and take control, unlikely but not impossible if prompted by Taiwan's declaration of independence. Lee Kuan Yew, in his speech in Fudan University a couple years ago, had spelled out his concern and reasoning very well. Messr. Lee believes the older generation, having been through the difficult time, would treasure what they have achieved today. It is the new generation, who grows up after 1978 (incidentally also the spoiled generation as single child in the family), that LKY worries about. This new generation, with no baggage and no memory of tough days in the Cultural Revolution, and provoked by "China containment" and "Japanese revisionist", are the most likely supporters of the new hawks. (We can draw parallel to the new generation of Japanese leader borned after WWII, who have taken control of Japanese Diet today) LKY believes China needs to focus on education on the new generation. More international exposure will also help. Let's also hope the government is on the path to become more liberal and democratic, by then the Taiwan or Tibet issues will resolve by themselves. I am optimistic.

I have tried to illustrate the points from China's perspective and from the historical and current thinking within Chinese academics and strategist. A numbers of western observers have recognized similar pattern from their own observations (Benjamin Schwarz of The Atalntic, Sebastian Mallaby of Washington Post, Barnett, etc). My blog focuses on business and economic issues. Unfortunately the issue of "China threat" theory has emerge persistently to muddle with economic issues. I shall return to the originally intended theme of this blog after this post, but comments, questions and challenges are more than welcome.

P.S. As Washington is finishing its Report on China's Military Status, and is expected to again bring back the "China threat" theory on the agenda, I hope the Chinese links I quoted (and paraphrased) can offer a view into the current debates within China, and in particular, the debate within China's academics and strategists, hence some insight into where China is really heading.

Update (Sep1): China's White Paper on Arms Reduction

defense spending as % of GDP, as % of budget

X-axis: US, Russia, UK, France, Japan, China