Zhu Rongji's Hidden Weapon: Devaluation

China's premier could cut the yuan-dollar rate this year.
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As China's premier Zhu Rongji negotiates with the U.S. this week for entry into the World Trade Organization, one strong card he will almost certainly play is his country's decision to hold its currency firm while much of Asia devalued.

The U.S., however, would be wise to question how long China intends to stick with a fixed-exchange-rate regime, as evidence is mounting a devaluation could occur by year-end.

The yuan is fixed at 8.28 to the dollar and is not fully convertible. Maintaining this fixed-rate regime has won the Chinese government kudos from Western financial and political leaders. They believe the Asian crisis would have been a lot worse if Beijing had decided to let the yuan go.

This praise for the exchange-rate policy counts for a lot, and Chinese leaders have often said they have no intention of devaluing the yuan, a development that could disrupt the Asian giant's relationships with the rest of the world.

"Politically, the Chinese get a boost from not devaluing at a time when they have little else to draw on in relations with the U.S.," says Avery Goldstein, a China specialist at the

University of Pennsylvania


Goldstein, however, recognizes that if the Chinese economic growth looks like its going to fall below 6% -- which would make it the slowest year since the crunch of 1990 -- the authorities may well consider making their currency cheaper.

Many commentators have tried to play down the economic forces that could cause a devaluation. That would be foolish.

One claim is that China doesn't need to devalue to solve its economic problems. The China bulls argue the government's huge spending plans can keep the economy going until a recovery in Asia, the destination for half of China's exports, begins in earnest.

True, last year's official growth rate, a bulky 7.8% if compared with more mature economies but underwhelming taken alongside China's recent accomplishments, was achieved through enormous state investment spending. The government aims to continue the splurge, laying out a massive $1 trillion over the 1998-2000 period.

But remarks at last month's

National People's Congress

, including some by Zhu himself, suggest the Chinese realize this strategy is deeply flawed and likely unsustainable.

The problem is a lot of the investment is directed by state-owned banks into state-owned enterprises. Huge sums are being wasted in inefficient companies just to bolster growth and employment. This reverses the government's original plans to shut down as many SOEs as possible and clean bad loans off its banks' balance sheets. Now, past-due loans are estimated to be equivalent to 30% of total loans. One day the government will have to pay for these -- and it knows it.

The other suspect claim is devaluation wouldn't have much of a positive impact, something that is rejected by Andy Xie, China economist at

Morgan Stanley Dean Witter

in Hong Kong. "There's no doubt that an exchange-rate adjustment would have economic benefits," he says.

Among the benefits would be a boost to sectors that are getting creamed by competitors in Asian countries with devalued currencies, says Nick Lardy, China expert at the

Brookings Institution

. These are hardly peripheral industries. Lardy lists chemicals, steel and shipbuilding.

Most important, perhaps, a devaluation would also allow China to loosen money supply, which has been kept unnecessarily tight to keep cash from seeping out of the country. Morgan Stanley's Xie says money supply ought to be growing at 25% a year instead of the current 16%.

In an attempt to stop the black-market leakage of dollars -- estimated at $60 billion last year -- the Chinese had to recently hike interest rates despite the fact that inflation appears to be comatose, if not dead. The rate hike is a sign the authorities are deeply worried about the fall in reserves, says Jim Walker, economist at

Credit Lyonnais Securities Asia

. To pave the way for a much-needed rate cut, he expects the Chinese will float the yuan in the second half of this year. They might do it earlier, he says, if it were not for the summer celebrations of the 50th anniversary of the establishment of the People's Republic of China.

To be sure, a big deterrent to freeing the yuan is the large amount of dollar debt held by Chinese companies. If devaluation took place, these obligations would immediately become much harder to pay for companies with revenues mainly in yuan. As in many other Asian countries that devalued, a wave of bankruptcies could occur.

Lardy estimates total dollar debt at $200 billion, about $60 billion more than foreign currency reserves. That sum looks daunting. Morgan Stanley's Xie says it is much less of an obstacle now since the maturities of the debts have been lengthened.