For all the hot air expended over whether the Chinese yuan is under- or overvalued, it's really a moot issue.
As any economist worth a quarter of their Wall Street salary will tell you, there's no way to gauge the yuan's true market value so long as capital is barred from flowing freely into and out of China's economy. And, in the next breath, that same economist will likely explain that for all its emphasis on "internationalizing" the Chinese currency, Beijing is in no hurry to break open the capital account. To allow true convertibility would be to concede an even more important power: The ability to tightly control the interest-rate spread that Chinese banks operate under.
When to Sell the Yen
The Japanese currency's days as a safe haven may be numbered.
This is why a recent research report from Deutsche Bank was eye-catching. The bank's economists argue that because of the internationalization drive, interest-rate liberalization is already happening at a pace much faster than suits the government, which wants to achieve it over a gradual, two-decade process.
In a shift with profound implications for the rest of the world but especially commodity-producing nations, China's multitudinous and diligently frugal savers are increasingly looking for better returns on their hard-earned cash than is currently offered by the closely managed banks.
As economists like Michael Pettis of Peking University have patiently explained for years, China's rapid-fire growth has depended on the financial repression of these people. Deliberate policies allowed banks to capture their colossal pool of savings, pay them paltry government-mandated deposit rates, and turn these funds into cheap bank loans for exporters, state-owned firms and municipal governments. Much of that was used to fuel a manic construction drive that has gobbled up boatloads of Australian iron ore, Chilean copper and Indonesian coal.
Now these borrowers, as well as the banks that service them, face the risk of an abrupt end to this bonanza. As the Deutsche Bank economists explain, the government's moves to internationalize the yuan by opening up offshore trading centers for the Chinese currency in Hong Kong and in other financial centers, and by facilitating foreign trade invoicing in yuan, have gradually pried open the Chinese capital account. That naturally broadens the investment opportunities for a lucky few, which reduces the pool of available savings for banks and forces them to offer more attractive rates to capture funds.
Hence the proliferation of "wealth management" funds. These invest in corporate bonds and other higher-paying instruments and pay up to 4.5 percentage points more than the official deposit rate, which at 3.5% leaves savers with a negative return when compared with the most recent inflation readout of 3.6%. The wealth management funds have often been associated with loan sharks and other participants in China's illegal "shadow banking" system but, with banks themselves increasingly offering them, authorities are being forced to take a softer line.
The Supreme Court last month reversed a lower court's death penalty for a 28-year-old businesswoman, convicted of defrauding investors, following an outcry that reflected a widely held view that fault lies more with the policy of financial repression than with those who offer ways around it.
The government has also launched a pilot program in Wenzhou in Zhejiang province to permit deregulated community banks. The plan borrows from the special economic zones with which Shenzhen and other coastal cities were transformed into manufacturing hubs, but it faces the problem that money, unlike goods and people, cannot easily be locked down in one place. The slow drip of financial liberalization could soon give way to a flood.
The Deutsche Bank economists say interest rates could double in a few years because of these pressures. The good news: That will improve the allocation of capital to more productive sectors of the economy and end the repression of savers, helping China foster the consumer society the world needs it to become. The bad news: A sharp move in rates could wreak havoc with China's economic performance and with its banks.
"It is too late for policymakers to turn back the clock," Deutsche Bank says. "Instead, they should act urgently to recapitalize the banks so that they can meet the challenges of a more competitive financial system."
The obvious implication for currency traders from such a disruption is that it would hurt the Australian dollar and any others that are tied to Chinese demand.
But what about the yuan itself? All things being equal, if interest-rate and capital-account liberalization happened together and rapidly, traders would have the wherewithal and the motive (higher rates) to bid the yuan higher. But in reality, the blow to growth would prompt yuan-weakening capital flight and lead the central bank to devalue the exchange rate in support of exporters.
Either way, if Deutsche Bank's prognosis is correct, expect a lot more volatility in the China trade.—Michael Casey is managing editor for the Americas at DJ FX Trader, a foreign exchange news service jointly produced by Dow Jones Newswires and The Wall Street Journal. His new book on the global financial system, "The Unfair Trade," will be published on May 29. He can be reached at email@example.com.